ANSWERS TO QUESTIONS FOR CHAPTER 1(Questions are in bold print followed by answers.)1. What is the difference between a financial asset and a tangible asset?A tangible asset is one whose value depends upon certain physical properties, e.g. land, capital equipment and machines. A financial asset, which is an intangible asset, represents a legal claim to some future benefits or cash flows. The value of a financial asset is not related to the physical form in which the claim is recorded.2. What is the difference between the claim of a debtholder of General Motors and an equityholder of General Motors?The claim of the debt holder is established by contract, which specifies the amount and timing of periodic payments in the form of interest as well as term to maturity of the principal. The debt holder stands as a creditor and in case of default, he has a prior claim on firm assets over the equity-holder.The equity holder has a residual claim to assets and income. He can receive funds only after other claimants are satisfied. Income is in terms of dividends, the amount and timing of which are not certain.3. What is the basic principle in determining the price of a financial asset?The price of any financial asset is the present value of the expected cash flows or a stream of payments over time. Thus, the basic variables in determining the price are: expected cash flows, discount rate and the timing of these cash flows.4. Why is it difficult to determine the cash flow of a financial asset?The estimation and determination of cash flows is difficult because of several reasons. These include accounting measures, possibility of default of the issuer, and embedded options in the security. Interest payments can also change over time. There is uncertainty as to the amount and the timing of these payments.5. Why are the characteristics of an issuer important in determining the price of a financial asset?The characteristics of the issuer are important because these determine the riskiness or uncertainty of the expected cash flows. These characteristics, which determine the issuers creditworthiness or default risk, have an impact on the required rate of return for that particular financial asset.6. What are the two principal roles of financial assets?The first role of financial assets is to transfer funds from surplus spending units (i.e. persons or institutions with funds to invest) to deficit spending units (i.e. persons or firms needing funds to invest in tangible assets).The second role is to redistribute risk among persons or institutions seeking and providing funds. Funds providers share the risks of expected cash flows generated by tangible assets.7. In September 1990, a study by the U.S. Congress, Office of Technology Assessment, entitled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included this statement: Securities markets have five basic functions in a capitalistic economy:a. They make it possible for corporations and governmental units to raise capital.b. They help to allocate capital toward productive uses.c. They provide an opportunity for people to increase their savings by investing in them.d. They reveal investors judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers.e. They generate employment and income. For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function.The five economic functions of a financial market are: (1) transferring funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, (2) transferring funds in such a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets, (3) determining the price of financial assets (price discovery), (4) providing a mechanism for an investor to sell a financial asset (to provide liquidity), and (5) reducing the cost of transactions.The five economic functions stated in the Congressional Study can be classified according to the above five functions:1. “they make it possible for corporations and governmental units to raise capital” -functions 1 and 2;2. “they help to allocate capital toward productive uses” - function 3;3. “they provide an opportunity for people to increase their savings by investing in them” - functions 1 and 5;4. “they reveal investors judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers” -function 3;5. “they generate employment and income” - follows from functions 1 and 2 allowing those who need funds to use these funds to create employment and income opportunities.8. Explain the difference between each of the following:a. money market and capital marketb. primary market and secondary ma