Tutorial 1: Overview of Finance

1. Discuss the term asymmetric information. Why do you think this concept might be important
to you and to other market participants in the financial system? Give an example.

• It means different participants in the markets have different sets of information. Some
participants possess special or inside information that others do not possess.
• Some market participant may be able to earn excess profits by taking advantage of the
special information they possess in e.g. stock, currency and bond market
• E.g. stock market: Insider information of the corporate merger and acquisition
• E.g. currency market: Government devalues its currency such as the yuan devaluation
by the Chinese government in 2016
• E.g. bond market: Interest rate increase by the U.S. Federal Reserves

2. What functions of the financial system do the following transactions illustrate or represent?

Elaborate the answers.

(a) James purchases health and accident insurance policies offered by AIA
Risk protection
(b) Lee uses her credit card to purchase books
Payment, credit
(c) Fearing slowdown in economy, central banks around the world lower interest rates
Monetary policy
(d) The government sells bonds to cover its budget deficit
Debt, fiscal policy
(e) Needing immediate spending power, A Corporation sells its holding of government
bonds to raise funds

Liquidity

(f) A Corporation places some of its current earnings in commercial deposit

(h) Carl and Jane hope to put their young children through college someday. Accordingly,

they begin buying U.S. treasury bills.

Savings, wealth creation, liquidity, risk protection

• Consumption (C): Expenditure by consumer, relate to interest rates

4. What is agency problem, and how it may impact the goal of maximization of shareholders’
wealth?

The agency problem is a result of the separation of owners and managers, where managers do
what’s in their own best interests rather than what is in the best interest of the shareholders.
Large firms are typically run by professional managers who own a small fraction of the firms’
equity. The individual actions of these managers are often motivated by self-interest, which
may result in managers not acting in the best interests of the firm’s owners. When this happens
the firm’s owners will lose value.

5. What is the relationship between financial decision making and risk-return? Would all
financial manager view risk-return trade-offs similarly?

Almost all financial decisions involve some sort of risk-return trade-off. The more risk the firm
is willing to accept, the higher the expected return for the given course of action. For example,
in the area of working capital management, the less inventory held, the higher the expected
return, but also the greater the risk of running out of inventory. While one manager might
accept a given level of risk, another more risk-averse manager may not accept that level of
risk. This does not mean that one manager is correct and one is not; rather, it only means that
not all managers will view the risk-return trade-off in the same manner.

6. You are considering an investment that you expect will produce 8% return next year and you
expect that your real rate of return on this investment will be 6%. What do you expect inflation
to be next year?

Nominal (quoted) rate of return: 8%

Real return rate: 6%

The formula for the inflation rate if one is to ignore the cross product is:

Inflation = Nominal (quoted) rate of return – Real return rate

Inflation = 8% – 6% = 2%

7. If the real-risk free rate of interest is 4.8% and the rate of inflation is expected to be constant
at a level of 3.1%, what would expect 1-year Treasury bills rate of return?

Nominal = 4.8% + 3.1% = 7.9%

8. What is an investment banker? What functions it performs?

The investment banker is a middleman involved in the channeling of savings into long-term
investment. He performs the functions of: (1) underwriting; (2) distributing; (3) advising. By
assuming underwriting risk, the investment banker and his syndicate purchase the securities
from the issuer and hope to sell them at a higher price. Distributing the securities means getting
those financial claims into the hands of the ultimate investor. This is accomplished through the
syndicate’s selling group. Finally, the investment banker can provide the corporate client with
sound advice on which type of security to issue, when to issue it, and how to price it.

9. Why might a large corporation raise fund through private placement than IPO?

Several positive benefits are associated with private placements. The first is speed. Funds can
be obtained quickly, primarily due to the absence of a required registration with the SEC.
Second, flotation costs (i.e. marketing, distribution expenses) are lower compared to public
offerings of the same dollar size. Third, owners can select investors that are “friendly” to them.
This prevent future “hostile” takeover which is prevalent in the U.S.

10. Explain opportunity cost with respect to the firm cost of fund?

As a net user of funds, a firm must raise funds in the financial markets, either in the form of
debt or of equity. Also, since there will be other entities in need of funds, including both
businesses and governments, the firm must offer the investor a return that is attractive, given
the investor’s next best opportunity. Thus, the cost of money to the firm will invariably be
determined by the investor’s next best opportunity for the given level of risk being assumed—
that is, the investor’s opportunity cost. Otherwise, the investor will not be interested in
purchasing the company’s bonds or stocks. We should never base our decisions on past or
historical costs, even when they represent the actual out-of-pocket costs to the firm. Maximizing
shareholder wealth means that we make decisions based upon our understanding of the
investor’s best alternative opportunities. In the case of investment and financing decisions, the
opportunity cost for the firm’s investors is captured in the rates of return available in the
financial markets.