Chapter 1: An Introduction to Finance

Multiple Choice Questions 1. According to Canadas national balance sheet, which of the following items is not a real asset? A. Land B. Machinery and equipment C. Net worth D. Residential structures Level of difficulty: Medium Solution: C. Net worth = Assets Debts. Examples of real assets are residential structures, non-residential structures, machinery and equipment, durables, inventories, and land. 2. In business finance, managers make capital expenditure decisions, which may include all of the following except: A. Land purchases B. Takeovers of another firm C. Inventory purchases D. Salary payment Level of difficulty: Easy Solution: D. 3. Consider the following environments. Which one would cause a firm to make different decisions about capital expenditures and corporate financing than it would otherwise? A. High unemployment rate B. High real gross domestic produce (GDP) growth rate C. High corporate profits D. Low interest rates Level of difficulty: Difficult Solution: A. High real GDP growth rate and low unemployment rate are key macroeconomic indicators of a good economy environment, where corporate profits are high and interest rates are low. Therefore A (high unemployment) is an indication of a weak environment and might cause different decisions. Capital expenditure and corporate financing decisions are made based on these macroeconomic factors. 4. Which of the following is a correct combination of primary fund lenders and fund borrowers in the financial system? A. Households; government B. Households; non-residents C. Businesses; households D. Government; non-residents Level of difficulty: Medium Solution: A.

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In the financial system, households are the primary fund providers to the government and businesses. 5. Which of the following financial intermediaries does not transform the nature of the underlying financial securities? A. Banks B. Insurance firms C. Mutual funds D. Pension funds Level of difficulty: Medium Solution: C. Banks, pension funds, and insurance firms do transform the nature of their underlying financial securities. However, mutual funds do not transform the nature of the underlying financial securities. Practice Problems 6. State the four major financial sectors in the financial system and discuss how they relate to one another. Level of difficulty: Medium Solution: In the financial system, there are mainly four major financial sectors, which are personal finance, government finance, corporate finance, and international finance. They closely interrelate to each other. Because they are all major parts of the whole financial system, what happens in one market will affect all the other markets. 7. Explain how banks, pension funds, insurance firms, and mutual funds work in the financial system. Level of difficulty: Medium Solution: Banks take in deposits and loan them out to fund borrowers. Pension funds take in pension contributions and pay out pensions to plan participants when they retire. Insurance firms take in premiums and pay out when a certain event occurs. Mutual funds pool small funds together and make investments that small investors cannot make. Mutual funds also offer investment expertise to ordinary investors. 8. Briefly describe why financial and market intermediaries exist in our financial system. Level of difficulty: Medium Solution: Five main reasons why financial and market intermediaries exist are: i) They provide anonymousness and convenience to all transaction parties. ii) They efficiently match the needs of the participants in the financial market and aggregate all the small transactions. iii) They have procedures for documentation of legal contracts to ensure security. iv) The risk of non-payment is alleviated by maintaining credit ratings and by controlling other accounts. v) Financial institutions transform the nature of the underlying financial securities. 9. List the two main types of primary market transactions and concisely explain them. Level of difficulty: Medium
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Solution: The two main types of primary market transactions are initial public offerings (IPOs), which are offered to the public by previously private firms, and seasoned equity offerings (SEOs), which are offered by firms previously listed on the stock exchange. 10. What are secondary market transactions? How do secondary markets facilitate the primary markets? Level of difficulty: Difficult Solution: Secondary market transactions are those where ownership of existing shares changes hands, but the firms receive no financing. This is critical to the functioning of the primary markets, because governments and companies would not be able to raise financing if investors were unable to sell their investments if necessary.

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