Chapter_2
.pdf42)The largest depository institution at the end of 2004 was
A)life insurance companies.
B)pension funds.
C)state retirement funds.
D)none of the above.
Answer: D
Question Status: Previous Edition
43)Which of the following financial intermediaries are depository institutions?
A)A savings and loan association
B)A commercial bank
C)A credit union
D)All of the above
E)Only A and C of the above
Answer: D
Question Status: Previous Edition
44)Which of the following is a contractual savings institution?
A)A life insurance company
B)A credit union
C)A savings and loan association
D)A mutual fund
Answer: A
Question Status: Previous Edition
45)Which of the following are not investment intermediaries?
A)A life insurance company
B)A pension fund
C)A mutual fund
D)Only A and B of the above
Answer: D
Question Status: Previous Edition
46)Which of the following are investment intermediaries?
A)Finance companies
B)Mutual funds
C)Pension funds
D)All of the above
E)Only A and B of the above
Answer: E
Question Status: Previous Edition
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47)The government regulates financial markets for three main reasons:
A)to ensure soundness of the financial system, to improve control of monetary policy, and to increase the information available to investors.
B)to improve control of monetary policy, to ensure that financial intermediaries earn a normal rate of return, and to increase the information available to investors.
C)to ensure that financial intermediaries do not earn more than the normal rate of return, to ensure soundness of the financial system, and to improve control of monetary policy.
D)to ensure soundness of financial intermediaries, to increase the information available to
investors, and to prevent financial intermediaries from earning less than the normal rate of return.
Answer: A
Question Status: Previous Edition
48)Which of the following government regulations has the chief purpose of improving control of the money supply?
A)deposit insurance
B)restrictions on entry into banking or insurance
C)reserve requirements
D)restrictions on the assets financial intermediaries can hold
Answer: C
Question Status: Previous Edition
49)Asymmetric information can lead to widespread collapse of financial intermediaries, referred to as a
A)bank holiday.
B)financial panic.
C)financial disintermediation.
D)financial collapse.
Answer: B
Question Status: Previous Edition
50)Foreign currencies that are deposited in banks outside the home country are known as
A)foreign bonds.
B)Eurobond.
C)Eurocurrencies.
D)Eurodollars.
Answer: C
Question Status: New
51)U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. are referred to as
A)Eurodollars.
B)Eurocurrencies.
C)Eurobonds.
D)foreign bonds.
Answer: A
Question Status: New
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52)Banks providing depositors with checking accounts that enable them to pay their bills easily is known as
A)liquidity services.
B)asset transformation.
C)risk sharing.
D)transaction costs.
Answer: A
Question Status: New
53)A ________ is when one party in a financial contract has incentives to act in its own interest rather than in the interests of the other party.
A)moral hazard
B)risk
C)conflict of interest
D)financial panic
Answer: C
Question Status: New
54)Fire and casualty insurance companies are what type of intermediary?
A)Contractual savings institution
B)Depository institutions
C)Investment intermediaries
D)None of the above Answer: A
Question Status: New
55)The country whose banks are the most restricted in the range of assets they may hold is
A)Japan.
B)Canada.
C)Germany.
D)the United States.
Answer: D
Question Status: New
2.2True/False
1)Every financial market allows loans to be made. Answer: FALSE
Question Status: Previous Edition
2)An example of direct financing is if you were to lend money to your neighbor. Answer: TRUE
Question Status: Previous Edition
3)The New York Stock Exchange is an example of a primary market. Answer: FALSE
Question Status: Previous Edition
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4)A bond denominated in euros and issued in a country that uses the euro as its currency is an example of a Eurobond.
Answer: FALSE
Question Status: Previous Edition
5)Most people's involvement with the financial system is through financial intermediaries rather than financial markets.
Answer: TRUE
Question Status: Previous Edition
6)A financial intermediary's risk-sharing activities are also referred to as asset transformation. Answer: TRUE
Question Status: Previous Edition
7)The process of financial intermediation is also known as direct finance. Answer: FALSE
Question Status: Previous Edition
8)A mutual fund is not a depository institution. Answer: TRUE
Question Status: Previous Edition
9)A pension fund is not a contractual savings institution. Answer: FALSE
Question Status: Previous Edition
10)Equity represents an ownership interest in a firm and entitles the holder to the residual cash flows.
Answer: TRUE
Question Status: Previous Edition
11)Adverse selection refers to those most at risk being most aggressive in their search for funds. Answer: TRUE
Question Status: Previous Edition
12)The capital market is a financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded.
Answer: FALSE
Question Status: New
13)American investors pay attention to only the Dow Jones Industrial Average. Answer: FALSE
Question Status: New
14)The government agency that insures each depositor at a commercial bank, savings and loan association, or mutual savings bank up to a loss of $100,000 per account ($250,000 for individual retirement accounts) is the Securities and Exchange Commission (SEC). Answer: FALSE
Question Status: New
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2.3Essay
1)Distinguish between direct financing and indirect financing.
Question Status: Previous Edition
2)Distinguish between primary markets and secondary markets.
Question Status: Previous Edition
3)Distinguish between money and capital markets.
Question Status: Previous Edition
4)Why is it so important for an economy to have fully developed financial markets?
Question Status: Previous Edition
5)Why are financial intermediaries so important to an economy?
Question Status: Previous Edition
6)Describe how over-the-counter markets work.
Question Status: Previous Edition
7)What are adverse selection and moral hazard?
Question Status: Previous Edition
8)Why can a financial intermediary's risk-sharing activities be described as asset transformation?
Question Status: Previous Edition
9)Discuss the differences between depository institutions, contractual savings institutions, and investment intermediaries.
Question Status:
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CHAPTER TWO
Introduction to the Financial Statements
Concept Questions
C2.1. The change in shareholders’ equity is equal earnings minus net payout to shareholders only if earnings are comprehensive earnings. See equation 2.4. Net income, calculated according to U.S. GAAP is not comprehensive because some income (“other comprehensive income”) is booked as other comprehensive income outside of net income. See equation 2.5.
C2.2. False. Cash can also be paid out through share repurchases.
C2.3. Net income available to common is net income minus preferred dividends. The earnings per share calculation uses net income available to common (divided by shares outstanding)
C2.4. For one of two reasons:
1.The firm is mispriced in the market.
2.The firm is carrying assets on its balance sheet at less than market value, or is omitting other assets like brand assets and knowledge assets. Historical cost accounting and the immediate expensing of R&D and expenditures on brand creation produce balance sheets that are likely to be below market value.
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C2.5. P/E ratios indicate growth in earnings. The numerator (price) is based on expected future earnings whereas the denominator is current earnings. If future earnings are expected to be higher than current earnings (that is, growth in earnings is expected), the P/E will be high. If future earnings are expected to be lower, the P/E ratio will be low. So differences in P/E ratios are determined by differences in growth in future earnings from the current level of earnings. P/E ratios could also differ because the market incorrectly forecasts future earnings. Chapter 6 elaborates.
C2.6. Accounting value added is comprehensive earnings that a firm reports for a period, and is equal to the change in book value plus the net dividend (net payout): see equation 2.4. Shareholder value added is the change in shareholder wealth for the period, equal to the change in the value of the investment plus the net dividend: see equation 2.7. Accounting value added is earnings from selling products to customers in the current period. Shareholder valued added incorporates not only current earnings but also anticipations of future earnings not yet booked in the accounting records.
C2.7. Some examples:
Expensing research and development expenditures.
Using short estimated lives for depreciable assets – resulting is high depreciation charges.
Expensing store opening costs before revenue is received.
Not recognizing the cost of stock options.
Expensing advertising and brand creation costs.
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Underestimating bad debts
Not recognizing contingent warranty liabilities from sales of products.
See Box 2.3.
C2.8. Accounting methods that would explain the high P/B ratios in the 1990s:
More of firms’ assets were in intangible assets (knowledge, marketing skill, etc.) – and thus not on the balance sheet – rather than in tangible assets than are booked to the balance sheet.
Firms became more conservative in booking tangible net assets (that is they carried them at lower amounts on the balance sheet), by recognizing more liabilities such as pension and post-employment liabilities and by carrying assets at lower amounts through restructuring charges, for example.
The other factor: stock prices rose above fundamental value, adding to the difference between price and book value.
C2.9. Dividends are distributions of the value created in a firm; they are not a loss in generating value. So accountants calculate the value added (earnings), add it to equity, and then treat dividends as a distribution of the value created (by charging dividends against equity in the balance sheet).
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C2.10. Plants wear out. They rust and become obsolescent. So value in the original investment is lost. Accordingly, depreciation is an expense in generating value from operations, just as wages are.
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C2.11. Like depreciation of plant, amortization of intangibles recognizes a loss of value. Patents expire, and so the value of the original investment is lost. So, just as the cost of plant is expensed against the revenue the plant produces, the cost of patents is expensed against the revenue that the patent produces.
C2.12. Matching nets expenses against the revenues they generate. Revenues are value added to the firm from operations; expenses are value given up in earning revenues. Matching the two gives the net value added, and so measures the success in operations. Matching uncovers profitability.
C2.13. The fundamental analyst wants to anchor on “what we know” so not to mix “what we know” with speculation. So he tells the accountants: Tell me what you know, don’t speculate; leave the speculation to me, the analyst. The reliability criterion enforces this request.
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