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CHAPTER 2

THE FINANCIAL MARKETS AND INTEREST RATES

TRUE/FALSE

  1. External funding will be high during a recession characterized by low corporate profits and high inflation.

Answer:False; Difficulty: 2; Keywords: External Funding

  1. Corporations rely mainly on the sale of common stock to finance their investment projects.

Answer:False; Difficulty: 1; Keywords: Corporate Financing, Common Stock

  1. Corporations are generally net savers that attempt to transfer cash to shareholders via financial market transactions.

Answer:False; Difficulty: 1; Keywords: Financial Markets, Net Savers

  1. A corporation needing cash sells securities to investors in the secondary market.

Answer:False; Difficulty: 1; Keywords: Secondary Market

  1. Significant amounts of funds for U.S. corporations are supplied by foreign investors.

Answer:True; Difficulty: 1; Keywords: Net Funds Supplied, Foreign Sector

  1. Only individual investors participate in public offerings, while institutional investors participate in private placements.

Answer:False; Difficulty: 1; Keywords: Public Offering, Private Placement

  1. Venture capitalists typically provide funds to high-risk start up companies but take no active role in their management.

Answer:False; Difficulty: 1; Keywords: Venture Capitalist

  1. Seasoned secondary offerings occur in the secondary market.

Answer:False; Difficulty: 1; Keywords: Seasoned Secondary Offering, Secondary Market

  1. Capital markets are all institutions and procedures that facilitate transactions in long-term financial instruments.

Answer:True; Difficulty: 1; Keywords: Capital Markets

  1. Transactions in the futures markets involve current payments for goods which will be delivered at some future agree upon date.

Answer:False; Difficulty: 1; Keywords: Futures Market

  1. Organized stock exchanges provide the benefits of a continuous market, fair security pricing, and helping businesses raise new capital.

Answer:True; Difficulty: 1; Keywords: Organized Stock Exchanges

  1. More stocks are traded on organized exchanges, while more corporate bonds are traded over-the-counter.

Answer:False; Difficulty: 1; Keywords: Organized Stock Exchanges, Over-The-Counter Markets

  1. Stocks listed on the New York Stock Exchange must be traded exclusively on the NYSE in order to maintain the high standards set by the exchange.

Answer:False; Difficulty: 1; Keywords: New York Stock Exchange

  1. The difference between the price the corporation gets and the public offering price is called the broker-dealer spread.

Answer:False; Difficulty: 1; Keywords: Investment Banker, Broker-Dealer, Spread

  1. The need for extensive regulation of investment banking firms is limited due to the highly competitive nature of that industry.

Answer:False; Difficulty: 1; Keywords: Investment Banking, Concentration

  1. The investment banker performs three basic functions: (1) underwriting, (2) distributing, and (3) advising.

Answer:True; Difficulty: 1; Keywords: Investment Banker

  1. The negotiated purchase is the most prevalent method of securities distribution in the private sector.

Answer:True; Difficulty: 1; Keywords: Negotiated Purchase, Investment Banking

  1. When a corporation sells securities directly to the investment public without involving an investment banker, it is called a privileged subscription.

Answer:False; Difficulty: 1; Keywords: Privileged Subscription, Investment Banking

  1. An investment banker assumes underwriting risk in both negotiated purchases and privileged subscriptions with standby agreements.

Answer:True; Difficulty: 2; Keywords: Negotiated Purchase, Standby Agreements, Investment Banking

  1. All common stocks are traded on either the New York Stock Exchange or the American Stock Exchange in the United States.

Answer:False; Difficulty: 1; Keywords: Stock Exchange, NYSE, AMEX

  1. One advantage of organized stock exchanges is increased stock price volatility resulting from the efficient exchange of pricing information.

Answer:False; Difficulty: 2; Keywords: Stock Exchange, Price Volatility

  1. Due to listing requirements, companies with losses must be de-listed from the New York Stock Exchange until they return to profitability.

Answer:False; Difficulty: 1; Keywords: NYSE, Listing Requirements

  1. Investment banking firms are prohibited from selling securities due to conflicts of interest.

Answer:False; Difficulty: 1; Keywords: Investment Banker

  1. Over time, there has been a high correlation between actual rates of return on securities and the securities’ standard deviations of returns.

Answer:True; Difficulty: 1; Keywords: Risk/Return Tradeoff, Standard Deviation, Actual Return

  1. Flotation costs are typically greater in the secondary market than in the primary market.

Answer:False; Difficulty: 1; Keywords: Flotation Costs, Secondary Market, Primary Market

  1. Each purchase occurring in the secondary markets increases the total stock of financial assets that exist in the economy.

Answer:False; Difficulty: 1; Keywords: Secondary Markets

  1. The money market includes transactions in short-term financial instruments.

Answer:True; Difficulty: 1; Keywords: Money Market

  1. Over-the-counter markets include all security markets, with the exception of organized exchanges.

Answer:True; Difficulty: 1; Keywords: Over-the-counter Markets, Organized Exchanges

  1. For a firm to have its securities listed on an exchange, it must meet certain requirements. These usually include measures of profitability, size, market value, and public ownership.

Answer:True; Difficulty: 1; Keywords: Stock Exchange, Listing Requirements

  1. Transactions in common stock occur in the money market, due to the large amount of money involved in such transactions.

Answer:False; Difficulty: 2; Keywords: Money Market, Common Stock

  1. The syndicate can be thought of as a wholesaler of securities and the dealer organization as a retailer of securities.

Answer:True; Difficulty: 1; Keywords: Syndicate, Dealer Organization, Securities

  1. A group of investment bankers organized to distribute large securities issues is known as a syndicate.

Answer:True; Difficulty: 1; Keywords: Syndicate, Investment Bankers

  1. It is common practice among the largest corporations to sell their securities directly to investors.

Answer:False; Difficulty: 1; Keywords: Securities, Direct Placement

  1. The investment banker prefers to avoid a negotiated purchase because it tends to be the least profitable arrangement for the investment banker.

Answer:False; Difficulty: 2; Keywords: Negotiated Purchase, Investment Banker

  1. The competitive bid purchase is largely confined to railroad, public utility, and municipal bond issues.

Answer:True; Difficulty: 2; Keywords: Competitive Bid Purchase

  1. The bid price is the price that a dealer will pay for a security; the asked price is the price at which she will sell a security.

Answer:True; Difficulty: 1; Keywords: Bid Price, Asked Price, Securities

  1. In the aggregate, households usually spend more on current consumption than they earn.

Answer:False; Difficulty: 2; Keywords: Households, Net Savers

  1. Because they occur in private, stricter regulations are placed on the private placement of securities.

Answer:False; Difficulty: 2; Keywords: Private Placements, Securities

  1. Financial markets exist in order to allocate savings in the economy to the demanders of those savings.

Answer:True; Difficulty: 1; Keywords: Financial Markets

  1. If a firm has unused debt capacity and the general level of equity prices is depressed, financial executives will favor the issuance of debt securities over the issuance of new common stock.

Answer:True; Difficulty: 2; Keywords: Debt vs. Equity Financing

  1. In a typical year, when new funds are being raised, corporate debt markets outweigh corporate equity markets in terms of dollar volume.

Answer:True; Difficulty: 2; Keywords: Corporate Debt Markets, Corporate Equity Markets

  1. Registration of securities by the SEC indicates to investors that the risk of those securities is reasonable.

Answer:False; Difficulty: 2; Keywords: SEC, Registration of Securities

  1. Financial intermediaries issue their own indirect securities and use the proceeds to purchase the direct securities of other economic units.

Answer:True; Difficulty: 1; Keywords: Financial Intermediaries, Indirect Securities, Direct Securities

  1. Corporate debt markets clearly dominate the corporate equity markets when new funds are being raised.

Answer:True; Difficulty: 2; Keywords: Debt Markets, Equity Markets

  1. The rate of return available on the next best investment alternative for the saver refers to the opportunity cost of funds.

Answer:True; Difficulty: 1; Keywords: Opportunity Cost of Funds

  1. Investors expect to receive the highest returns from government-issued securities because the government will not default on securities that it has issued.

Answer:False; Difficulty: 2; Keywords: Risk/Return Tradeoff

  1. Real assets are tangible, whereas financial assets merely reflect claims for future payment on other economic units.

Answer:True; Difficulty: 2; Keywords: Real Assets, Financial Assets

  1. In a private placement, the securities are offered and sold to a limited number of investors.

Answer:True; Difficulty: 1; Keywords: Private Placement, Securities

  1. The process of shelf registration is beneficial to the issuing firm because it will reduce the time needed for the firm to take an issue to market.

Answer:True; Difficulty: 1; Keywords: Shelf Registration, Securities

  1. The term structure of interest rates usually indicates that longer terms to maturity have higher expected returns.

Answer:True; Difficulty: 2; Keywords: Term Structure of Interest Rates

MULTIPLE CHOICE

  1. Which of the following statements is an example of a futures market transaction?
  2. An investor purchases 100 shares of IBM hoping to sell it in two years for a profit.
  3. A company purchases an option to buy 1000 barrels of oil anytime between now and the end of the year.
  4. A company agrees to purchase 1000 barrels of oil for delivery in six months at a price of $70 per barrel.
  5. An executive has a portion of his current year salary deferred until he retires.

Answer:c; Difficulty: 2; Keywords: Futures Market

  1. When a company repurchases its own common stock, it is likely that ______.
  2. the stock price will increase because the company views the stock as undervalued
  3. the stock price will decrease because the company is creating artificial demand for its stock
  4. the stock price will remain the same as this is simply an internal transaction
  5. the board of directors will be fired for incompetence

Answer:a; Difficulty: 2; Keywords: Common Stock, Share Repurchase

  1. General Electric (GE) has been a public company for many years with its common stock traded on the New York Stock Exchange. If GE decides to sell 500,000 shares of new common stock, the transaction will be described as ______.
  2. an initial public offering
  3. a secondary market transaction because GE common stock has been trading for years
  4. a seasoned equity offering because GE has sold common stock before
  5. a money market transaction because GE raises new money to fund its business

Answer:c; Difficulty: 2; Keywords: Seasoned Equity Offering

  1. Which of the following statements concerning private placements is most correct?
  2. Private placements do not involve investment bankers.
  3. Although not selling the securities to the public, investment bankers may provide advice on the evaluation of prospective buyers and the terms of sale for private placements.
  4. Private placements are limited to stocks, not bonds.
  5. More than half of all private placements are sold to federal, state, or local governments or government agencies.

Answer:b; Difficulty: 1; Keywords: Private Placement, Investment Banking

  1. Which of the following is an advantage of using private placements for debt?
  1. reduced costs from the elimination of the registration statement for the SEC, investment-banking underwriting fees and distribution costs
  2. lower interest costs
  3. fewer and less burdensome restrictive covenants
  4. the possibility of future SEC registration

Answer:a; Difficulty: 2; Keywords: Private Placement

  1. The nominal interest rate is 9% and the expected inflation rate is 4%. Based on the Fisher effect, the real rate of interest is ______.
  2. 5.0%
  3. 2.08%
  4. 4.8%
  5. 1.0%

Answer:c; Difficulty: 2; Keywords: Fisher Effect, Real Rate of Interest, Nominal Interest Rate

  1. Money market instruments include:
  2. common stock
  3. preferred stock
  4. T-bonds
  5. T-bills

Answer:d; Difficulty: 1; Keywords: Money Market, T-bills

  1. A basis point is equal to ______.
  2. one percent
  3. one-tenth of one percent
  4. one-hundredth of one percent
  5. one-half of one percent

Answer:c; Difficulty: 1; Keywords: Basis Point

  1. The prime lending rate is the base rate on ______.
  2. mortgage loans
  3. home equity loans
  4. auto loans
  5. corporate loans

Answer:d; Difficulty: 1; Keywords: Prime Rate

  1. The internal capital market deals with the allocation of internally generated cash between ______.
  2. stockholders, creditors, and corporate capital projects
  3. stockholders and managers
  4. corporate capital projects of differing business segments within the corporation
  5. capital gains and capital losses

Answer:a; Difficulty: 2; Keywords: Internal Capital Market

  1. Which of the following will likely result in a greater use of external funding?
  2. higher corporate profits and higher interest rates
  3. lower corporate profits and lower interest rates
  4. higher corporate profits and lower interest rates
  5. lower corporate profits and higher interest rates

Answer:b; Difficulty: 2; Keywords: External Funding, Corporate Profits, Interest Rates

  1. U.S. corporations finance their activities ______.
  2. mainly with equity because equity does not expire or need to be paid back
  3. mainly with corporate debt, partially because the U.S. tax system favors debt over equity
  4. mainly with equity because the U.S. tax system favors equity over debt
  5. equally with debt and equity

Answer:b; Difficulty: 2; Keywords: Capital Markets, Corporate Funding, Debt vs. Equity

  1. Which of the following statements is most correct?
  2. The after-tax cost of debt is greater than the after-tax cost of preferred stock.
  3. The after-tax cost of debt is higher than the cost of common equity.
  4. The cost of preferred stock is generally higher than the after-tax cost of debt.
  5. Federal taxes favor corporate dividends over the interest costs associated with debt.

Answer:c; Difficulty: 1; Keywords: Cost of debt, Preferred Stock, Capital Structure

  1. John calls his stockbroker and instructs him to purchase 100 shares of Microsoft Corporation common stock. This transaction occurs in the ______.
  2. secondary market
  3. primary market
  4. credit market
  5. futures market

Answer:a; Difficulty: 1; Keywords: Secondary Market, Primary Market

  1. A life insurance company purchases $1 billion of corporate bonds from premiums collected on its life insurance policies. Therefore, ______.
  2. the corporate bonds are indirect securities and the life insurance policies are direct securities
  3. the corporate bonds are indirect securities and the life insurance policies are indirect securities
  4. the corporate bonds are direct securities and the life insurance policies are indirect securities
  5. the corporate bonds are direct securities and the life insurance policies are direct securities

Answer:c; Difficulty: 2; Keywords: Direct Securities, Indirect Securities

  1. Investment firms, such as Goldman Sachs, assist the transfer of capital by ______.
  2. facilitating indirect transfers from savers (investing public) to borrowers (corporations needing capital)
  3. selling indirect securities to savers and using the funds to buy common stock for corporations needing funds
  4. selling direct securities
  5. selling common stock for corporate clients in the secondary market

Answer:a; Difficulty: 1; Keywords: Investment Banker, Capital Transfer

  1. A corporation sells securities to an investment banking firm on January 1st. The next day an international oil crisis causes stock prices to drop dramatically. The corporation is immune from the drop in price of its stock due to which function of the investment banking firm?
  2. hedging
  3. distributing
  4. reinsurance
  5. underwriting

Answer:d; Difficulty: 2; Keywords: Investment Banker, Underwriting

  1. If a corporation wants a guarantee that all of its shares of stock will be sold, it should use which of the following distribution methods?
  2. competitive bid purchase
  3. privileged subscription with no standby agreement
  4. commission or best-efforts contract
  5. direct sale

Answer:a; Difficulty: 2; Keywords: Investment Banking, Competitive Bid Purchase

  1. Reynolds, Inc. needs to raise $5 million by selling common stock. Reynolds sells 1 million shares of stock at $5 each to Goldman Sachs, who then is responsible for selling the shares to investors. This is an example of a ______.
  2. privileged subscription
  3. standby agreement
  4. negotiated purchase
  5. commission or best-efforts agreement

Answer:c; Difficulty: 2; Keywords: Negotiated Purchase, Investment Banking

  1. Spandra Electronics wants to raise money by selling stock. After talking to several investment banking firms, Spandra decides to hire Goldman Sachs to sell 5 million shares of its common stock. Goldman sells 4.5 million shares and returns the rest to Spandra. This is an example of ______.
  2. a privileged subscription with a standby agreement
  3. a commission or best-efforts agreement
  4. a privileged subscription with a standby agreement
  5. a competitive bid purchase

Answer: b; Difficulty: 2; Keywords: Commission or Best-Efforts Agreement, Investment Banking

  1. General Motors raises money by selling a new issue of common stock. This transaction occurs in ______.
  2. the secondary market
  3. the capital market
  4. the money market
  5. the futures market

Answer:b; Difficulty: 1; Keywords: Capital Market

  1. Which of the following is an example of both a capital market and a primary market transaction?
  2. The U.S. Government sells 3-month Treasury Bills
  3. Microsoft common stock owned by an individual investor is sold to another investor
  4. Ford Motor Company sells a new issue of common stock to raise funds through a public offering
  5. No transactions occur in both primary and capital markets at the same time.

Answer:c; Difficulty: 2; Keywords: Primary Market, Capital Market

  1. All of the following securities are sold in money markets except:
  2. common stock
  3. commercial paper
  4. 3-month U.S. Treasury Bills
  5. 6-month certificates of deposit

Answer:a; Difficulty: 1; Keywords: Money Market, Commercial Paper, Treasury Bills

  1. Which of the following is an advantage of organized stock exchanges?
  2. increased stock price volatility
  3. screening companies to ensure only low risk stocks are sold
  4. providing a continuous market
  5. only profitable companies may issue new securities on an organized exchange

Answer:c; Difficulty: 1; Keywords: Organized Stock Exchanges, Continuous Market