Fin 303 chap 1&2 review questions

Briefly define the terms proprietorship, partnership, and corporation.

A proprietorship is a business owned by one person. Two or more people who join together to form a business make up a partnership. This can be done on an informal basis without a written partnership agreement, or a contract can spell out the rights and responsibilities of each partner. A limited liability company is a hybrid between a partnership and a corporation. Profits and losses pass through to the members. Members generally enjoy limited liability. Corporations are legal entities separate from their owners. To form a corporation, the owners specify the governing rules for the running of the business in a contract known as the articles of incorporation. They submit the articles to the government of the state in which the corporation is formed, and the state issues a charter that creates the separate legal entity.

What is an agent? What are the responsibilities of an agent?

An agent is a person who has the implied or actual authority to act on behalf of another. The owners whom the agents represent are the principals. Agents have a legal and ethical responsibility to make decisions that further the interests of the principals.

What is the role of a broker in security transactions? How are brokers compensated?

Brokers handle orders to buy or sell securities. Brokers are agents who work on behalf of an investor. When investors call with an order, brokers work on their behalf to find someone to take the other side of the proposed trade. If investors want to buy, brokers find sellers. If investors want to sell, brokers find buyers. Brokers are compensated for their services when the person whom they represent, the investor, pays them a commission on the sale or purchase of securities.

Who owns a credit union? Explain.

Credit unions are owned by their members. When credit union members put money in their credit union, they are not technically "depositing" the money. Instead, they are purchasing shares of the credit union. In general, credit unions exist to pay interest on shares bought by, and collect interest on loans made to, the members.

How are financial trades made on an organized exchange?

Each exchange listed security is traded at a specified location on the trading floor called the post. The trading is supervised by specialists who act either as brokers (bringing together buyers and sellers) or as dealers (buying or selling the stock themselves). Prominent international securities exchanges include the New York Stock Exchange (NYSE) and major exchanges in Tokyo, London, Amsterdam, Frankfurt, Paris, Hong Kong, and Mexico.

List and describe the three career opportunities in the field of finance.

Finance has three main career paths: financial management, financial markets and institutions, and investments. Financial management involves managing the finances of a business. Financial managers—people who manage a business firm's finances—perform a number of tasks. They analyze and forecast a firm's finances; assess risk, evaluate investment opportunities, decide when and where to find money sources and how much money to raise, and decide how much money to return to the firm's investors. Bankers, stockbrokers, and others who work in financial markets and institutions focus on the flow of money through financial institutions and the markets in which financial assets are exchanged. They track the impact of interest rates on the flow of that money. People who work in the field of investments locate, select, and manage income-producing assets. For instance, security analysts and mutual fund managers both operate in the investment field.

How is finance related to the disciplines of accounting and economics?

Financial management is essentially a combination of accounting and economics. First, financial managers use accounting information—balance sheets, income statements, and so on—to analyze, plan, and allocate financial resources for business firms. Second, financial managers use economic principles to guide them in making financial decisions that are in the best interest of the firm. In other words, finance is an applied area of economics that relies on accounting for input.

Describe the duties of the financial manager in a business firm.

Financial managers measure the firm's performance, determine what the financial consequences will be if the firm maintains its present course or changes it, and recommend how the firm should use its assets. Financial managers also locate external financing sources and recommend the most beneficial mix of financing sources, and they determine the financial expectations of the firm's owners. All financial managers must be able to communicate, analyze, and make decisions based on information from many sources. To do this, they need to be able to analyze financial statements, forecast and plan, and determine the effect of size, risk, and timing of cash flows.

What are financial markets? Why do they exist?

Financial markets are where financial securities are bought and sold. They exist primarily to bring deficit economic units (those needing money) and surplus economic units (those having extra money) together.

Compare and contrast a defined benefit and a defined contribution pension plan.

In a defined benefit plan, retirement benefits are determined by a formula that usually considers the worker's age, salary, and years of service. The employee and/or the firm contribute the amounts necessary to reach the goal. In a defined contribution plan, the contributions to be made by the employee and/or employer are spelled out, but retirement benefits depend on the total accumulation in the individual's account at the retirement date.

How are financial trades made in an over the counter market? Discuss the role of a dealer in the OTC market.

In contrast to the organized exchanges, which have physical locations, the over the counter market has no fixed location, or more correctly, it is everywhere. The over the counter market, or OTC, is a network of dealers around the world who maintain inventories of securities for sale. If you wanted to buy a security that is traded OTC, you would call your broker, who would then shop among competing dealers who have the security in their inventory. After locating the dealer with the best price, your broker would buy the security on your behalf.The role of dealers: Dealers make their living buying securities and reselling them to others. They operate just like car dealers who buy cars from manufacturers for resale to others. Dealers make money by buying securities for one price (called the bid price) and selling them for a higher price, (called the ask price). The difference, or spread, between the bid price and the ask price represents the dealer's fee.

What can a financial institution often do for a deficit economic unit (DEU)that it would have difficulty doing for itself if the DEU were to deal directly with an SEU?

SEUs typically want to supply a small amount of funds, while DEUs typically want to obtain a large amount of funds. Thus it is often difficult for surplus and deficit economic units to come together on their own to arrange a mutually beneficial exchange of funds for securities. A financial institution can step in and save the day. A bank, savings and loan, or insurance company can take in small amounts of funds from many individuals, form a large pool of funds, and then use that large pool to purchase securities from individual businesses and governments. (This is just one example of the beneficial things financial institutions do for DEUs)

What is a security?

Securities are claims on financial assets. They can be described as "claim checks" that give their owners the right to receive funds in the future. Securities are traded in both the money and capital markets. Money market securities include Treasury bills, negotiable certificates of deposit, commercial paper, and banker's acceptances. Capital market securities include bonds and stock.

Compare and contrast mutual and stockholder-owned savings and loan associations.

Some savings and loan associations are owned by stockholders, just as commercial banks and other corporations are owned by their stockholders. Other S&Ls, called mutuals, are owned by their depositors. When a person deposits money in an account at a mutual S&L, that person becomes a part owner of the firm. The mutual S&L's profits (if any) are put into a special reserve account from which dividends are paid from time to time to the owner/depositors.

Describe how society's interests can influence financial managers.

Sometimes the interests of a business firm's owners are not the same as the interests of society. For instance, the cost of properly disposing of toxic waste can be so high that companies may be tempted to simply dump their waste in nearby rivers. In so doing, the companies can keep costs low and profits high, and drive their stock prices higher (if they are not caught). However, many people suffer from the polluted environment. This is why we have environmental and other similar laws: So that society's best interests take precedence over the interests of individual company owners. When businesses take a long-term view, the interests of the owners and society often (but not always) coincide. When companies encourage recycling, sponsor programs for disadvantaged young people, run media campaigns promoting the responsible use of alcohol, and contribute money to worthwhile civic causes, the goodwill generated as a result of these activities causes long-term increases in the firm's sales and cash flows, which translate into additional wealth for the firm's owners.

Explain why accounting profits and cash flows are not the same thing.

Stock value depends on future cash flows, their timing, and their riskiness. Profit calculations do not consider these three factors. Profit, as defined in accounting, is simply the difference between sales revenue and expenses. It is true that more profits are generally better than less profits, but when the pursuit of short-term profits adversely affects the size of future cash flows, their timing, or their riskiness, then these profit maximization efforts are detrimental to the firm.

What can a financial institution often do for a surplus economic unit that it would have difficulty doing for itself if the surplus economic unit (SEU) were to deal directly with a deficit economic unit (DEU)?

Surplus economic units do not usually have the expertise to determine whether deficit economic units can and will make good on their obligations, so it is difficult for them to predict when a would-be deficit economic unit will fail to pay what it owes. Such a failure is likely to be devastating to a surplus economic unit that has lent a proportionately large amount of money. In contrast, a financial institution is in a better position to predict who will pay and who won't. It is also in a better position, having greater financial resources, to occasionally absorb a loss when someone fails to pay. (This is just one example of the beneficial things financial institutions do for SEUs)

Define intermediation.

The financial system makes it possible for surplus and deficit economic units to come together, exchanging funds for securities, to their mutual benefit. When funds flow from surplus economic units to a financial institution to a deficit economic unit, the process is known as intermediation. The financial institution acts as an intermediary between the two economic units.

What is the basic goal of a business?

The primary financial goal of the business firm is to maximize the wealth of the firm's owners. Wealth, in turn, refers to value. If a group of people owns a business firm, the contribution that firm makes to that group's wealth is determined by the market value of that firm.

Which type of insurance company generally takes on the greater risks: a life insurance company or a property and casualty insurance company?

The risks protected against by property and casualty companies are much less predictable than are the risks insured by life insurance companies. Hurricanes, fires, floods, and trial judgments are all much more difficult to predict than the number of sixty-year-old females who will die this year among a large number in this risk class. This means that property and casualty insurance companies must keep more liquid assets than do life insurance companies.

Compare and contrast the potential liability of owners of proprietorships, partnerships (general partners), and corporations.

The sole proprietor has unlimited liability for matters relating to the business. This means that the sole proprietor is responsible for all the obligations of the business, even if those obligations exceed the amount the proprietor has invested in the business. Each partner in a partnership is usually liable for the activities of the partnership as a whole. Even if there are a hundred partners, each one is technically responsible for all the debts of the partnership. If ninety-nine partners declare personal bankruptcy, the hundredth partner still is responsible for all the partnership's debts. A corporation is a legal entity that is liable for its own activities. Stockholders, the corporation's owners, have limited liability for the corporation's activities. They cannot lose more than the amount they paid to buy the corporation's stock.

What are the characteristics of an efficient market?

The term market efficiency refers to the ease, speed, and cost of trading securities. In an efficient market, securities can be traded easily, quickly, and at low cost. Markets lacking these qualities are considered to be inefficient.

List and explain the three financial factors that influence the value of a business.

The three factors that affect the value of a firm's stock price are cash flow, timing, and risk. The Importance of Cash Flow: In business, cash is what pays the bills. It is also what the firm receives in exchange for its products and services. Cash is therefore of ultimate importance, and the expectation that the firm will generate cash in the future is one of the factors that gives the firm its value. The Effect of Timing on Cash Flows: Owners and potential investors look at when firms can expect to receive cash and when they can expect to pay out cash. All other factors being equal, the sooner companies expect to receive cash and the later they expect to pay out cash, the more valuable the firm and the higher its stock price will be. The Influence of Risk: Risk affects value because the less certain owners and investors are about a firm's expected future cash flows, the lower they will value the company. The more certain owners and investors are about a firm's expected future cash flows, the higher they will value the company. In short, companies whose expected future cash flows are doubtful will have lower values than companies whose expected future cash flows are virtually certain.

What is a Treasury bill? How risky is it?

Treasury bills are short term debt instruments issued by the U.S. Treasury that are sold at a discount and pay face value at maturity. They are very nearly risk-free as they are backed by the U.S. Government which could, if need by, print money to pay their holders at maturity.

What are a bank's primary reserves? When the Fed sets reserve requirements, what is its primary goal?

Vault cash and deposits in the bank's account at the Fed are used to satisfy these reserve requirements; they are called primary reserves. These primary reserves are non-interest-earning assets held by financial institutions. The Federal Reserve requires all commercial banks to keep a minimum amount of reserves on hand to meet the withdrawal demands of its depositors and to pay other obligations as they come due. Many would argue, however, that the reserve requirement is set more with monetary policy in mind than to ensure that banks meet their depositors' withdrawal requests.

Would there be positive interest rates on bonds in a world with absolutely no risk (no default risk, maturity risk, and so on)? Why would a lender demand, and a borrower be willing to pay, a positive interest rate in such a no risk world?

Yes, there would be a positive rate of interest in a risk-free world. This is because regardless of risk, lenders of money must postpone spending during the time the money is loaned. Lenders, then, lose the opportunity to invest their money for that period of time. To compensate for the cost of losing investment opportunities while they postpone their spending, lenders demand, and borrowers pay, a basic rate of return, the real rate of interest.