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Elizabeth Patrick Assignment 1.2 - Chap.

2 Warm Up Exercises

MBA 504: Financial Management

E2-1 What does it mean to say that individuals as a group are net suppliers of funds for financial institutions? What do you think the consequences might be in financial markets if individuals consumed more of their incomes and thereby reduced the supply of funds available to financial institutions? Ans. Individual as groups are net suppliers of the funds for financial institution means that the individuals who deposit their money into financial institutions is the main source of finance which is collected by these institutions and further distributed as loans etc. If individuals consume more income and save less income in banks the fund supply of financial institution will reduce and the rate of borrowing from bank will increase. In other words the interest on loan will be higher.

E2-2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion design firm. Your firm needs $10 Million dollars to expand production. How do you think the process of raising this money will vary if you raise it with the help of financial institution versus raising it directly in the financial markets? Ans. The finance of $10million if taken up from financial institution Gaga Enterprises will have to give interest on the loan taken up. On the other hand, if it directly raises the money form the financial market. Gaga enterprises can do so in 2 ways one by equity the other by debt if raising money via equity it will have to pay dividend and if issuing money via debt it will have to pay interest it can also raise $ 10 million via combo of both equity and debt, which ever is best suited according to the minimum interest to be paid.

E2-3 For what kinds of needs do you think a firm would issue securities in the money market versus the capital market? Ans. If a firm invests in the money market is solely because it has some idle funds which by investing in money market will generate a interest in form of income. Investment in money market is for less than one year hence it is also called short term investment. If a firm invests in capital market it is for a long term period generally more than one year. Investment in capital market is generally in bonds and shares both equity and preference.

E2-4 Your broker calls to offer you the investment opportunity of a lifetime, the chance to invest in mortgage-backed securities. The broker explains that these securities are entitled to the principal and

Elizabeth Patrick

MBA 504: Financial Management

interest payments received from a pool of residential mortgages. List some questions you would ask your broker to assess the risk of this investment opportunity. Ans. When house prices are rising, the gap between what a borrower owes on a house and what the house is worth widens? How do rising house prices help in keeping the mortgage rate lower?

E2-5 Reston, Inc. has asked your corporation, Pruro, Inc. for financial assistance. As a long time customer of Reston, your firm has decided to give that assistance. The question you are debating is whether Pruro, Inc. should take Reston stock with 5% annual dividend or a promissory note paying 5% annual interest? Assuming payment is guaranteed and the dollar amounts for annual interest and dividend income are identical, which option will result in greater after tax income for the first year? Ans. As dividends give effect to double taxation its always beneficial to use interest as interest expenses or interest received are deductable expenses and give tax deduction. So in the above question, pruro should accept promissory note paying 5% annual interest as it will be beneficial in taxation of the company.