Chp 10: Financial Assets & Markets

Question 1

Roles of Financial Assets and Financial Markets?

Answer 1

Financial Assets:
• Claim on some future income
• A U.S. Treasury Bill
‐ A promise by the U.S. Treasury to pay a certain amount at a specified future date.
• Bonds - Issued by Government bodies
• Share (or stock) in a firm
‐ A promise (not guarantee) by the firm to pay the holder a portion of the profits.

Financial Markets:
• A financial market is the place or mechanism whereby financial assets are exchanged and prices of these assets are set.

Question 2

Functions of Financial Assets?

Answer 2

1) Means of transferring funds
• Businesses require funds for investment.
• Individuals have surplus funds
• Transfer of funds induces economic growth.

2) Means of transferring (sharing) risk
• Return on investments - uncertain
• Firm by using borrowed funds is transferring part of the risk to the lender.

Question 3

Functions of Financial Markets?

Answer 3

• A Marketplace can include: Stock Exchanges, Banks
• Markets provide a place where financial instruments (assets) can be sold/exchanged.
• Organised markets reduce costs of transaction.
• Provide information of current discount rates, helps in pricing of assets.

Question 4

Three major factors for valuation of financial assets?

Answer 4

1) Cash Flows:
• For shares ( Annual Dividends & Change in stock price)
• For Bonds (Amount of interest received & Change in price)

2) Growth Rate of Cash Flow
• Continuous cash flows.
• Positive rate of growth of cash flows.
• Risk to be controlled.

3) Risk or Uncertainty
The risks involved and the associated uncertainty in future cash flows of the asset would be reflected by the
discount rate.

Question 5

Definition of bond?

Answer 5

Meaning: Loan granted by any individual to an
organization, company, entity, etc. for a specified period at a fixed rate of return

Type of Right: Debt

Key Person(Owner): Bond Holder

Returns: Interest

Voting: No rights

The current value of a bond may be defined as the net
present value of:
• Cash flows representing interest payments.
• Cash flow representing the payment of face value on
maturity date.

Draw the CashFlow Diagram!!

Question 6

Explain the financial mechanism of Preference Stock, the risk to potential investors and how the valuation can be derived.

Answer 6

• Fundamental assumption is that stock be held to perpetuity
• Valuation of preferred stock is by discounting cashflow (i.e Dividend) for perpetuity
• Vp = D/K
• For Potential investors, no voting rights
• Another risk= Price Fluctuation Risk
• Due to fixed dividend rate, it is affected by interest rate fluctuation thus affect its price
• Another risk = Liquedation risk
• If company is liquedated, pay its creditors first then bondholders, finally preffered stockholders

Question 7

Value of Common stock?

Answer 7

• Depends on firm's dividend payment policy.
• Dividends not fixed, not guaranteed.
• Price of stock determined by:
      • Discount rate
      • Expected Annual dividend
      • Growth of dividends with time
               ‐ No growth
               ‐ Constant growth
               ‐ Unusual growth

•Gordon Model: Po= Do(1+g)/(K-g)

Question 8

Bond calcs procedures?

Answer 8

1) Identify interest payable is Annual/Sem-Annual/Quaterly

2) Calculate Interest Due= (Coupon Rate * Face Value)/B
where B=1 for Annual
B=2 for Semi-Annual
B=4 for Quaterly

3) Convert Market discount rate accordingly based on schedule of interest payable. (i.e divide 2 for semi annual, divide 4 for quarter)
4) Solve PV
5) PV> Price quoted = attractive