FIN221 Week 2 – T

Autumn 2009
CH1:QP3, 11, 18, 19 CH2: QP9, 12, 22, 25

1.3 Cash flows: Explain the difference between profitable and unprofitable firms.

Solution:

A profitable firm is able to generate more than enough cash through its

productive assets to cover its operating expenses, taxes, and payments to

creditors. If the firm has residual cash flows after all, such residual cash can be

used for dividend payments or reinvestments. A firm is unprofitable when it

fails to generate sufficient cash flows to pay operating expenses, creditors and

taxes. Firms that are unprofitable over time may be forced to declare

bankruptcy.

1.11 Organizational form: Who are the owners in a corporation, and how is their

ownership represented?

Solution:

The owners of a corporation are its stockholders or shareholders, and the

evidence of their ownership is represented by shares of common stock. Let’s

say FIN221 Ltd has 100 outstanding shares and you own 1 share. This

indicates that you own 1% of FIN221 Ltd.

1.18 Firm’s goal: What is the appropriate goal of financial managers? Can

managers’ decisions affect this goal in any way? If so, how?

Solution:

The appropriate goal of financial managers should be to maximize the current

value of the firm’s stock price. Managers’ decisions affect the stock price in

many ways as the value of the stock is determined by the future cash flows the

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 firm can generate. Managers can affect the cash flows by, for example,

selecting what products or services to produce, what type of assets to

purchase, or what advertising campaign to undertake.

1.19 Firm’s goal: What are the major factors affecting stock price?

Solution:

Importantly, management decisions affect the firm’s stock price. A basic

principle in finance is that the value of an asset is determined by the future

cash flows it is expected to generate and a firm’s management make major

financial decisions that affect its cash flows. All of capital budgeting decision,

financing decision and working capital management decision affect cash flows

both over the short-term and long-term.

Other external factors include economic conditions (recession or expansion),

war or peace and new government regulations.

2.9. Primary Markets: Identify whether the following transactions are primary

market or secondary market transactions.

a. Jim Hendry bought 300 shares of IBM through his brokerage

account.

b. Peggy Jones bought $5,000 of IBM bonds from the firm.

c. Hathaway Insurance Company bought 500,000 shares of Trigen

Corp. when the company issued stock.

Solution:

• secondary
• secondary
• primary

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2.12.Financial Institutions: What are some of the ways in which a financial

institution or intermediary can raise money?

Solution:

A financial intermediary can raise money through the sale of financial products

that individuals or businesses will purchase.

• The major sources of funds for commercial banks are consumers: checking

accounts, savings accounts, and a variety of time deposits. The banks

accumulate these funds and make a variety of loans to consumers,

businesses, and governments.

• Life insurance companies obtain funds by selling life insurance policies

that protect individuals against the loss of income from a family member’s

premature death.

• Casualty Insurance Companies sell protection against loss of property

from fire, theft, accidents, negligence, and other predictable causes.

• Pension funds provide retirement programs for businesses as part of their

employee benefit programs. They obtain money from employee and

employer contributions during the employee’s working years.

2.22 Capital Markets: How do capital market instruments differ from money

market instruments?

Solution:

Money markets are markets in which short-term debt instruments with

maturities of less than one year are bought and sold. Financial instruments

sold in money markets have very short maturities, usually overnight to 180

days, are highly marketable in that they can be easily converted into cash

and are issued by economic units of the highest credit standing.

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 Capital market is the segment of the marketplace where capital goods,

such as plant and equipment, are financed with equities or debt

instruments with maturities of more than one year. Capital market

instruments are less liquid or marketable therefore carry more financial

risk.

2.25 Interest Rates: What is the real rate of interest, and how is it determined?

Solution:

The real rate of interest measures the return earned on savings, and it

represents the cost of borrowing to finance capital goods. The real rate of

interest is determined by the interaction between firms that invest in capital

projects and the rate of return businesses can expect to earn on investments

in capital goods, and individuals’ time preference for consumption.

Graphically, it is that point when the desired saving level equals the desired

level of investment (spending) in the economy.