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Kingdom of Saudi Arabia
Ministry of Education
Saudi Electronic University
College of Administrative and Financial Sciences
Assignment 1
Principles of Finance (FIN 101)
Due Date: 22/07/2022 @ 23:59
Course Name: Principles of Finance
Studentâ€™s Name:
Course Code: FIN 101
Studentâ€™s ID Number:
Semester: Summer
CRN:
For Instructorâ€™s Use only
Instructorâ€™s Name:
Level of Marks: High/Middle/Low
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The Assignment must be submitted on Blackboard (WORD format only) via
allocated folder.
Assignments submitted through email will not be accepted.
Students are advised to make their work clear and well presented, marks may be
reduced for poor presentation. This includes filling your information on the cover
page.
Students must mention question number clearly in their answer.
Late submission will NOT be accepted.
Avoid plagiarism, the work should be in your own words, copying from students
or other resources without proper referencing will result in ZERO marks. No
exceptions.
All answered must be typed using Times New Roman (size 12, double-spaced)
font. No pictures containing text will be accepted and will be considered
plagiarism).
Submissions without this cover page will NOT be accepted.
Learning Outcomes:
1. Recognize the fundamental financial concepts and the financial environment of the
company. (1.1)
2. Describe the role of Time-Value-of-Money for making a decision. (1.2)
3. Measure financial corporate performance. (2.4)
Assignment Question(s): (6 x 2.5 = 15 Marks)
1. Critically Explain the phrase â€œa dollar today is worth more than a dollar tomorrow.â€
2. Ahmad deposits \$1,200 in her bank today. If the bank pays 4 percent simple
interest, how much money will she have at the end of five years? What if the bank
pays compound interest? How much of the earnings will be interest on interest?
3. Lemmon Enterprises has a total asset turnover of 2.1 and a net profit margin of
7.5%. If its equity multiplier is 1.90, what is the ROE for Lemmon Enterprises?
4. Critically explain the economic role of brokers and dealers. How does each make a
profit?
5. BBB company had cash and marketable securities worth \$400,134 accounts
payables worth \$2,490,357, inventory of \$1,321,500, accounts receivables of
\$2,188,128, short-term notes payable worth \$120,000, other current liabilities of
200,000, and other current assets of \$521,800. What is the company’s net working
capital?
6. If Bob and Judy combine their savings of \$1,260 and \$975, respectively, and
deposit this amount into an account that pays 2% annual interest, compounded
monthly, what will the account balance be after 4 years?
Chapter 1
The Financial Manager and the Firm
Learning Objectives
1. Identify the key financial decisions facing the financial manager of any business firm.
2. Identify the basic forms of business organization in the United States and their respective
strengths and weaknesses.
3. Describe the typical organization of the financial function in a large corporation.
4. Explain why maximizing the current value of the firmâ€™s stock is the appropriate goal for
management.
5. Discuss how agency conflicts affect the goal of maximizing shareholder value.
6. Explain why ethics is an appropriate topic in the study of corporate finance.
I.
Chapter Outline
1.1
The Role of the Financial Manager
A.
Stakeholders
B.
â€¢
The financial manager is responsible for making decisions that are in the best
interest of the firmâ€™s owners.
â€¢
A firm generates cash flows by selling the goods and services produced by its
productive assets and human capital. After meeting its obligations, the firm
1
can pay the remaining cash, called residual cash flows, to the owners as a cash
dividend, or it can keep the money and reinvest the cash in the business.
C.
Three Fundamental Decisions in Financial Management
â€¢
The capital budgeting decision: Which productive assets should the firm
buy? This is the most important decision because they drive the firmâ€™s
success or failure.
â€¢
The financing decision: How should the firm finance its assets?
â€¢
Working capital management decisions: How should day-to-day financial
matters be managed so that the firm can pay its bills, and how should
surplus cash be invested?
1.2
A.
A sole proprietorship is a business owned by one person.
â€¢
Sole proprietors keep all the profits from the business and do not have to share
decision making authority.
â€¢
All business income is taxed as personal income.
â€¢
The simplest and least regulated type of business to start.
â€¢
A sole proprietor is responsible for paying all the firmâ€™s bills and has unlimited
liability for all business debts and other obligations of the firm.
B.
A partnership consists of two or more owners joined together legally to manage a
2
â€¢
A general partnership has the same basic advantages and disadvantages as a sole
proprietorship.
â€¢
The problem of unlimited liability can be avoided in a limited partnership where
there must still be a general partner with unlimited liability.
C.
Corporations are legal entities authorized under a state charter.
â€¢
In a legal sense, it is a â€œpersonâ€ distinct from its owners.
â€¢
The owners of a corporation are its stockholders.
â€¢
A major advantage of the corporate form of business is that stockholders have
limited liability for debts and other obligations of the corporation.
â€¢
A major disadvantage of the corporate form of organization is taxes.
o The owners of corporations are subject to double taxationâ€”first at the
corporate level and then at the personal level when dividends are paid to
them.
â€¢
Some operate as a public corporation, which can sell their debt or equity in the
public securities markets.
â€¢
Others operate as a private corporation, where the common stock is often held by
a small number of investors, typically the management and wealthy private
backers.
D.
â€¢
Limited liability partnerships (LLPs) combine the limited liability of a corporation
with the tax advantage of a partnershipâ€”there is no double taxation.
â€¢
Limited liability companies (LLCs)
â€¢
Professional corporations (PCs)
3
1.3
Managing the Financial Function
A.
Organizational Structure
â€¢
The Chief Executive Officer has the final decision-making authority in the firm.
o Sets and executes the strategic plan for the firm.
o Reports directly to the board of directors, which is accountable to the
companyâ€™s owners.
â€¢
The Chief Financial Officer (CFO) has the responsibility for seeing that the best
possible financial analysis is presented to the CEO, along with an unbiased
recommendation.
B.
Positions Reporting to the CFO
o The treasurer looks after the collection and disbursement of cash,
investing excess cash so that it earns interest, raising new capital, handling
foreign exchange transactions, and overseeing the firmâ€™s pension fund
managers.
o The risk manager monitors and manages the firmâ€™s financial risk exposure
as well as the relationship with insurance providers.
o The controller typically prepares the financial statements, oversees the
firmâ€™s financial and cost accounting systems, prepares the taxes, and
works closely with the firmâ€™s external auditors. The position is really the
chief accounting officer.
4
o The internal auditor is responsible for in-depth risk assessments and for
performing audits of areas that have been identified as high-risk areas,
where the firm has the potential to incur substantial losses.
C.
External Auditors
â€¢
Provide an independent annual audit of the firmâ€™s financial statements.
o Ensure that the financial numbers are reasonably accurate and that
accounting principles have been consistently applied year to year and not
in a manner that significantly distorts the firmâ€™s performance.
D.
The Audit Committee
â€¢
Powerful subcommittee of the board of directors and has the responsibility of
overseeing the accounting function and preparing the firmâ€™s financial
statements.
â€¢
If necessary, it conducts investigations of significant fraud, theft, or
malfeasance in the firm.
E.
1.4
The Compliance and Ethics Director
The Goal of the Firm
A.
What Should Management Maximize?
â€¢
Minimizing risk or maximizing profits without regard to the other is not a
successful strategy.
B.
Why Not Maximize Profits?
â€¢
To a skilled accountant, however, a decision that increases profits under one
set of accounting rules can reduce it under another.
5
â€¢
Accounting profits are not necessarily the same as cash flows.
â€¢
The problem with profit maximization as a goal is that it does not tell us when
cash flows are to be received.
â€¢
C.
Profit maximization ignores the uncertainty or risk associated with cash flows.
Maximizing the Value of the Firmâ€™s Stock
â€¢
When analysts and investors determine the value of a firmâ€™s stock, they
consider:
o The size of the expected cash flows
o The timing of the cash flows
o The riskiness of the cash flows
â€¢
Thus, the mechanism for determining stock prices overcomes all the cashflow objections we raised with regard to profit maximization as a goal.
D.
Can Management Decisions Affect Stock Prices?
â€¢
Yes, management makes a series of decisions when executing the firmâ€™s
strategy that affect the firmâ€™s cash flows and, hence, the price of the firmâ€™s
stock.
1.5
Agency Conflicts: Separation of Ownership and Control
A.
Ownership and Control
â€¢
Once ownership and management are separated, managers may be tempted to
pursue goals that are in their own self-interest rather than the interests of the
owners.
B.
Agency Relationships
6
â€¢
An agency relationship arises whenever one party, called the principal, hires
another party, called the agent, to perform some service or represent the
principalâ€™s interest.
C.
Do Managers Really Want to Maximize Stock Price?
â€¢
Shareholders own the corporation, but managers control the money and have
the opportunity to use it for their own benefit.
â€¢
Agency costs arise due to a conflict of interest between the firmâ€™s owners and
its management.
D.
Aligning the Interests of Management and Stockholders
â€¢
Board of Directors: The board has the legal responsibility to represent
stockholderâ€™s interests. Its duties include hiring and firing the CEO, setting
his or her compensation, and monitoring his or her performance. The
board also approves major decisions concerning the firm.
â€¢
Management Compensation: A significant portion of management
compensation is tied to the performance of the firm, usually to the firmâ€™s
stock price.
â€¢
Management Labor Market
o Firms that have a history of poor performance or a reputation for
â€œshady operationsâ€ or unethical behavior have difficulty hiring top
managerial talent.
o The penalty for extremely poor performance or a criminal
conviction is a significant reduction in the managerâ€™s lifetime
7
earnings potential. Managers know this, and the fear of such
consequences helps keep them working hard and honestly.
â€¢
Other Managers
o Competition amongst managers helps provide incentives for
managers to act in the interest of shareholders.
â€¢
Large Stockholders: May have enough money and enough power for
them to actively monitor managers and to try to influence their decisions.
â€¢
The Takeover Market: If the interests of the manager and the firm are
not aligned, then eventually the firm will underperform relative to its true
potential, and the firmâ€™s stock price will fall below its maximum potential
price. With its stock underpriced, the firm will become a prime target for a
takeover by so-called corporate raiders or by other corporate buyers.
â€¢
The Legal and Regulatory Environment: Laws and regulations may
limit the ability of managers to make decisions that harm the interests of
shareholders.
E.
1.6
Sarbanes-Oxley and Other Regulatory Reforms
â€¢
Greater board independence
â€¢
Internal accounting controls
â€¢
Compliance programs
â€¢
Ethics program
â€¢
Expansion of audit committeeâ€™s oversight powers
The Importance of Ethics in Business
8
A.
â€¢
B.
Business ethics are a societyâ€™s ideas about what actions are right and wrong.
â€¢
Studies suggest that traditions of morality are very relevant to business and to
financial markets in particular.
â€¢
Corruption in business creates inefficiencies in an economy, inhibits the growth of
capital markets, and slows a countryâ€™s rate of economic growth.
C.
Types of Ethical Conflicts in Business
â€¢
Agency Costs â€“ Financial managers have an agency obligation to act honestly
and to see that subordinates also act honestly. However, revelations of dishonesty,
deception, and fraud in financial matters can have a large impact on the stock
price.
â€¢
Conflicts of Interestâ€”occur when the agentâ€™s interests are different from those
of the principal.
â€¢
Information Asymmetryâ€”occurs when one party in a business transaction has
information that is unavailable to the other parties in the transaction.
D.
The Importance of an Ethical Business Culture
â€¢
An ethical business culture means that people have a set of principles that helps
them identify moral issues and then make ethical judgments without being told
what to do.
E.
Serious Consequences
â€¢
In recent years, the â€œrulesâ€ have changed, and the legal cost of ethical mistakes
can be extremely high.
9
II.
Suggested and Alternative Approaches to the Material
This chapter presents a general survey of interesting topics in corporate finance. It begins with a
brief discussion of the role of the financial manager and is followed by an examination of the
different legal organizational forms of business. Although all of the most common organizational
forms are discussed, the most common form for the purposes of the remainder of the text is the
corporate form. The chapter then proceeds with the financial function of the manager and the
goal of the firm, which is to maximize shareholder value. It is this goal that requires that we
recognize its conflicts such as agency and ethical problems.
This chapter is intended to help students begin to understand the long list of interesting
problems that confront the financial manager and shareholders of the firm. While omitting this
chapter from a course syllabus will not necessarily diminish the direct understanding of the
material, such an omission could give the impression that the remaining material in the course is
mechanical in nature. Therefore, it is recommended that the instructor devote a lecture, or a
portion of a lecture, on the chapter in order to establish a proper basis for future chapter-related
discussions.
III. Summary of Learning Objectives
1.
Identify the key financial decisions facing the financial manager of any business
firm.
The financial manager faces three basic decisions: (1) which productive assets the firm
should buy (capital budgeting decisions), (2) how the firm should finance the productive
10
assets purchased (financing decisions), and (3) how the firm should manage its day-today financial activities (working capital decisions). The financial manager should make
these decisions in a way that maximizes the current value of the firmâ€™s stock.
2.
Identify the basic forms of business organization in the United States and their
respective strengths and weaknesses.
A business can organize in three basic ways: as a sole proprietorship, a partnership, or a
corporation (public or private). The owners of a firm select the form of organization that
they believe will best allow management to maximize the value of the firm. Most large
firms elect to organize as public corporations because of the ease of raising money; the
major disadvantage is double taxation. Smaller companies tend to organize as sole
proprietorships or partnerships. The advantages of these forms of organization include
ease of formation and taxation at the personal income tax rate. The major disadvantage is
the ownersâ€™ unlimited personal liability.
3.
Describe the typical organization of the financial function in a large corporation.
In a large corporation, the financial manager generally has the rank of vice president and
goes by the title of chief financial officer. The CFO reports directly to the firmâ€™s CEO.
Positions reporting directly to the CFO generally include the treasurer, the risk manager,
the controller, and the internal auditor. The audit committee of the board of directors is
also important in the financial function. The committee hires the external auditor for the
firm, and the internal auditor, external auditor, and compliance officer all report to the
audit committee.
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4.
Explain why maximizing the current value of the firmâ€™s stock is the appropriate
goal for management.
Maximizing stock value is an appropriate goal because it forces management to focus on
decisions that will generate the greatest amount of wealth for stockholders. Since the
value of a share of stock (or any asset) is determined by its cash flows, managementâ€™s
decisions must consider the size of the cash flow (larger is better), the timing of the cash
flow (sooner is better), and the riskiness of the cash flow (given equal returns, lower risk
is better.)
5.
Discuss how agency conflicts affect the goal of maximizing shareholder value.
In most large corporations, there is a significant degree of separation between
management and ownership. As a result, stockholders have little control over corporate
managers, and management may thus be tempted to pursue its own self-interest rather
than maximizing the value of the ownersâ€™ stock. The resulting conflicts give rise to
agency costs. Ways of reducing agency costs include developing compensation
agreements that link employee compensation to the firmâ€™s performance and having
independent boards of directors monitor management.
6.
Explain why ethics is an appropriate topic in the study of corporate finance.
If we lived in a world without ethical norms, we would soon discover that it would be
difficult to do business. As a practical matter, the law and market forces provide
important incentives that foster ethical behavior in the business community, but they are
12
not enough to ensure ethical behavior. An ethical culture is also needed. In an ethical
culture, people have a set of moral principlesâ€”a moral compassâ€”that helps them
identify ethical issues and make ethical judgments without being told what to do.
IV.
Summary of Key Equations
The chapter is primarily a qualitative chapter and does not have a relevant summary of key
equations.
13
Chapter 2
The Financial Environment and
the Level of Interest Rates
Learning Objectives
1. Describe the primary role of the financial system in the economy and the two basic ways
in which money flows through the system.
2. Discuss direct financing and the important role that investment banks play in this process.
3. Describe the primary, secondary, and money markets, explaining the special importance
of secondary and money markets to business organizations.
4. Explain what an efficient market is and why market efficiency is important to financial
managers.
5. Explain how financial institutions serve the needs of consumers, small businesses, and
corporations.
6. Compute the nominal and the real rates of interest, differentiating between them.
I.
Chapter Outline
2.1
The Financial System
A.
The Financial System at Work
â€¢
It is competitive.
â€¢
Money is aggregated in small amounts and loaned in large amounts.
â€¢
Directs money to the best investment opportunities in the economy.
1
â€¢
Banks earn much of their profits from borrowing at a low rate from depositors
and lending at a higher rate.
B.
How Funds Flow through the Financial System
â€¢
The primary concern of the financial system is funneling money from lenderssavers to borrowers-spenders.
2.2
ï‚§
Direct funds flow, or
ï‚§
Indirect funds flow (intermediation)
Direct Financing
Financial markets perform the important function of channeling funds from lenderssavers to borrowers-spenders.
A.
A Direct Market Transaction
â€¢
Direct Financial Marketsâ€”wholesale markets in which the borrower raises
capital from the market rather than borrowing from another institution.
â€¢
Investment Banksâ€”firms that specialize in helping companies sell new debt
or equity issues in the public or private security markets.
â€¢
Money Center Banksâ€”large commercial banks located in major U.S.
financial centers that transact in both the national and international money
markets.
ï‚§
Origination is the process of preparing a security issue for sale.
ï‚§
Underwritingâ€”a basic investment banking service is to assist firms in the
sale of debt or equity in the primary market. To underwrite a new security
issue, the investment banker buys the entire issue at a guaranteed price
2
from the issuing firm and resells the securities to institutional investors
and the public.
ï‚§
Distribution is the process of marketing and reselling the securities to
investors.
2.3
Types of Financial Markets
A.
Primary Marketâ€”any financial market in which new security issues are sold for
the first time.
B.
Secondary Marketâ€”any financial market in which the owners of outstading
securities can resell them to other investors.
â€¢
Investors are willing to pay higher prices for securities in primary markets if
the securities have active secondary markets.
â€¢
The ease with which a security can be sold and converted into cash is called
marketability.
â€¢
The ability to convert an asset into cash quickly without loss of value is called
liquidity.
â€¢
Brokersâ€”market specialists who bring buyers and sellers together in
secondary markets.
ï‚§
They execute transactions for their clients and are compensated for
their services with a commission fee.
ï‚§
They bear no risk of ownership of the securities in the transactions;
their only service is that of a â€œmatchmaker.â€
3
â€¢
Dealersâ€”â€œmake marketsâ€ for securities and do bear risk. They make a market
for a security by buying and selling from an inventory of securities they own.
The risk is that they will not be able to sell a security for more than they paid
for it.
C.
Exchanges and Over-the-Counter Markets
â€¢
Organized Exchangesâ€”provide a physical meeting place and communication
facilities for members to conduct business under a specific set of rules and
regulations. Only members can use the exchange, and each exchange has a
limited number of seats.
â€¢
Over-the-Counter (OTC) Marketsâ€”have no central trading location, as the
NYSE has. Instead, investors can execute OTC transactions by visiting or
telephoning an OTC dealer or by using a computer-based electronic trading
system linked to the OTC dealer.
D.
Money Marketsâ€” a collection of markets with no formal organization or
location, each trading distinctly different financial instruments. The minimum
transaction is \$1 million.
â€¢
Instruments include U.S. Treasury bills, negotiable CDs, and commercial
paper.
E.
Capital Marketsâ€”markets where equity and debt instruments with maturities of
greater than one year are traded.
F.
Public and Private Markets
â€¢
Public markets are organized financial markets where the general public
buys and sells securities through their stockbroker.
4
â€¢
Private markets involve direct transactions between two parties.
Transactions in private markets are called private placements.
G.
Futures and Options Marketsâ€”are often called derivative securities because
they derive their value from some underlying asset.
â€¢
Futures Contractsâ€”contracts for future delivery of securities, foreign
currencies, interest rates, or commodities.
â€¢
Options Contractsâ€”call for one party (the option writer) to perform a
specific act if called upon to do so by the option buyer or owner.
2.4
Market Efficiency
A.
Overview
â€¢
The supply and demand for securities are better reflected in organized
markets.
â€¢
Any price that balances the overall supply and demand for a security is a
market equilibrium price.
â€¢
A securityâ€™s true (intrinsic) value is the price that reflects investorsâ€™
estimates of the value of the cash flows they expect to receive in the future.
â€¢
In an efficient capital market, security prices fully reflect the knowledge and
expectations of all investors at a particular point in time.
ï‚§
If markets are efficient, investors and financial managers have no reason
to believe the securities are not priced at or near their true value.
5
ï‚§
The more efficient a security market, the more likely securities are to be
priced at or near their true value.
â€¢
The overall efficiency of a capital market depends on its operational efficiency
and its informational efficiency.
ï‚§ Market Operational efficiency focuses on bringing buyers and sellers
together at the lowest possible cost.
ï‚§ Markets exhibit informational efficiency if market prices reflect all
relevant information about securities at a particular point in time.
ï‚§ In an informationally efficient market, market prices adjust quickly to new
information about a security as it becomes available.
ï‚§ Competition among investors is an important driver of informational
efficiency.
B.
Efficient Market Hypotheses
â€¢
price that truly reflects the marketâ€™s consensus. This reflects the marketâ€™s
efficiency.
â€¢
Market efficiency can be explained at three levelsâ€”strong form, semistrong
form, and weak form.
â€¢
Strong-form market efficiency states that the price of a security in the market
reflects all informationâ€”public as well as private or inside information.
ï‚§
Strong-form efficiency implies that it would not be possible to earn
abnormally high returns (returns greater than those justified by the risks)
6
â€¢
Semistrong-form market efficiency implies that only public information that
is available to all investors is reflected in a securityâ€™s market price.
ï‚§
Investors who have access to inside or private information will be able to
earn abnormal returns.
ï‚§
Public stock markets in developed countries like the United States have a
semistrong-form of market efficiency.
ï‚§
â€¢
New information is immediately reflected in a securityâ€™s market price.
In weak-form market efficiency, all information contained in past prices of a
security is reflected in current prices.
ï‚§
It would not be possible to earn abnormally high returns by looking for
patterns in security prices, but it would be possible to do so by trading on
public or private information.
2.5
Financial Institutions and Indirect Financing
A.
Indirect Market Transactionsâ€”when a financial intermediary such as a
commercial bank or insurance company stands between the borrower and the
lender.
B.
Financial Institutions and Their Services
1. Commercial Banksâ€”are the most prominent and largest financial intermediaries
in the economy and offer the widest range of financial services to businesses.
â€¢
The major services commercial banks offer consumers are checking
accounts, savings accounts, and a variety of credit and loan arrangements.
â€¢
They also do a significant amount of equipment lease financing.
7
2. Life and Casualty Insurance Companiesâ€”obtain funds by selling life insurance
policies that protect individuals against the loss of income from a family
memberâ€™s premature death.
3. Casualty Insurance Companiesâ€”sell protection against loss of property from
fire, theft, accidents, negligence, and other predictable causes.
4. Pension Fundsâ€”provide retirement programs for businesses as part of their
employee benefit programs. They obtain money from employee and employer
contributions during the employeeâ€™s working years, and they provide monthly
payments upon retirement.
5. Investment Fundsâ€”sell shares to investors and use the funds to purchase
securities.
6. Business Finance Companiesâ€”sell short-terms IOUs, called commercial paper,
to investors in the direct credit markets, where these funds are used to make a
variety of short- and intermediate-term loans and leases to small and large
C.
2.6
Corporations and the Financial System
The Determinants of Interest Rate Levels
A.
The Real Rate of Interestâ€”a long-term interest rate determined in the absence of
inflation.
â€¢
The nominal rate of interest is the rate that we actually observe in the market
place at a given time and is unadjusted for inflation.
8
â€¢
The determinants of the real rate are a firmâ€™s return on investment as well as
the time preference for consumption. In equilibrium, the desired level of
borrowing by borrower-spenders equals the desired level of lending by lendersavers.
â€¢
Fluctuations in the Real Rate
o Any economic factor that causes a shift in the desired lending or desired
borrowing will cause a change in the equilibrium rate of interest.
o The real rate of interest reflects a complex set of forces that control the
desired level of lending and borrowing in the economy.
B.
Loan Contracts and Inflationâ€”the real rate of interest ignores inflation.
C.
The Fisher Equation and Inflation
â€¢
How do we write a loan contract that provides protection against loss of
â€¢
To incorporate â€œinflation expectationsâ€ into a loan contract we need to
adjust the real rate of interest by amount of inflation expected during the
contract period.
â€¢
The mathematical formula for this is called the Fisher Equation.
â€¢
( 1 + Nominal Rate) = (1 + Real Rate of interest) x (1 + Expected Price
Level Change)
â€¢
Simplified Fisher Equation: Nominal Rate = Real Rate of Interest +
Expected Price Level Change.
D.
Cyclical and Long-Term Trends in Interest Rates
â€¢
Inflationary expectations have a major impact on interest rates.
9
â€¢
economic expansion, interest rates tend to rise; during a recession, the
opposite tends to occur.
II.
Suggested and Alternative Approaches to the Material
This chapter provides useful background for the material presented later in the course. At some
universities, this material has already been covered in a previous course, and therefore the
chapter will serve as an optional review to ensure that the students are comfortable with the
nomenclature and general workings of the financial markets. In that event, this chapter can be
covered in a single lecture or a portion of a single lecture.
If the students have not had a previous course in Money and Banking, then the text offers
a proper introduction of the material. This might provide non-Finance majors with the only
source of this important material, such as the relationship between real and nominal interest
rates. In addition, the chapter introduces many definitions and concepts that will be used later in
the text.
III. Summary of Learning Objectives
1.
Describe the primary role of the financial system in the economy and the two basic
ways in which money flows through the system.
The role of the financial system is to gather money from people and businesses with
surplus funds to invest (lender-savers) and channel that money to businesses and
consumers who need to borrow money (borrower-spenders). If the financial system
10
works properly, only investment projects with high rates of return and good credit are
financed and all other projects are rejected. Money flows through the financial system in
two basic ways: (1) directly, through financial markets, or (2) indirectly, through
financial institutions.
2.
Discuss direct financing and the important role that investment banks play in this
process.
Direct markets are wholesale markets where large public corporations transact. These
corporations sell securities, such as stocks and bonds, directly to investors in exchange
for money, which they use to invest in their businesses. Investment banks are important
in the direct markets because they help firms sell their new security issues. The services
provided by investment bankers include origination, underwriting, and distribution.
3.
Describe the primary, secondary, and money markets, explaining the special
importance of secondary and money markets to business organizations.
Primary markets are markets in which new securities are sold for the first time.
Secondary markets provide the aftermarket for securities that were previously issued. Not
all securities have secondary markets. Secondary markets are important because they
enable investors to convert securities easily to cash. Business firms whose securities are
traded in secondary markets are able to issue securities at a lower cost than they
otherwise could because investors are willing to pay a premium price for securities that
have secondary markets.
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Large corporations use money markets to adjust their liquidity because cash inflows and
outflows are rarely perfectly synchronized. Thus, on the one hand, if cash expenditures
exceed cash receipts, a firm can borrow short-term in the money markets. If that firm
holds a portfolio of money market instruments, it can sell some of these securities for
cash. On the other hand, if cash receipts exceed expenditures, the firm can temporarily
invest the funds in short-term money market instruments. Businesses are willing to invest
large amounts of idle cash in money market instruments because of their high liquidity
and their low default risk.
4.
Explain what an efficient market is and why market efficiency is important to
financial managers.
An efficient market is a market where security prices reflect the knowledge and
expectations of all investors. Public markets, for example, are more efficient than private
markets because issuers of public securities are required to disclose a great deal of
information about these securities to investors and investors are constantly evaluating the
prospects for these securities and acting on the conclusions from their analyses by trading
them. Market efficiency is important to investors because it assures them that the
securities they buy are priced close to their true value.
5.
Explain how financial institutions serve the needs of consumers, small businesses,
and corporations.
One problem with direct financing is that it takes place in a wholesale market. Most small
businesses and consumers do not have the expert skills, financing requirements, or the
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money to transact in this market. In contrast, a large portion of the indirect market
focuses on providing financial services to consumers and small businesses. For example,
commercial banks collect money from consumers in small dollar amounts by selling them
checking accounts, saving accounts, and consumer CDs. They then aggregate the funds
and make loans in larger amounts to consumers and businesses. The financial services
bought or sold by financial institutions are tailor-made to fit the needs of the markets they
serve. Exhibit 2.3 illustrates how corporations use the financial system.
6.
Compute the nominal and the real rates of interest, differentiating between them.
Equations 2.1 and 2.2 are used to compute the nominal (real) rate of interest when you
have the real (nominal) rate and the inflation rate. The real rate of interest is the interest
rate that would exist in the absence of inflation. It is determined by the interaction of (1)
the rate of return that businesses can expect to earn on capital goods and (2) individualsâ€™
time preference for consumption. The interest rate we observe in the marketplace is
called the nominal rate of interest. The nominal rate of interest is composed of two parts:
(1) the real rate of interest and (2) the expected rate of inflation.
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IV.
Summary of Key Equations
Equation
2.1
Description
Fisher equation
Fisher equation
2.2
Formula
i = r + âˆ†P e + râˆ†P e
i = r + âˆ†P e
simplified
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