61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 1 - INTRODUCTION TO FINANCE & FINANCIAL MARKETS

The following questions must be attempted before the tutorial class.

Part 1 (tutorial 1)
1. 1-5

The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded on the basis of
the stock's performance over the long run, not the stock's price on an option exercise date. This
means that options (or direct stock awards) should be phased in over a number of years so the
CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be
measured in an objective and verifiable manner, then performance pay could be based on changes
in intrinsic value. However, it is easier to measure the growth rate in reported profits than the
intrinsic value, although reported profits can be manipulated through aggressive accounting
procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable,
compensation must be based on the stock's market price—b ut the price used should be an
average over time rather than on a specific date.
2. 1-6

Sole proprietorships, partnerships, corporations, limited liability corporations and partnerships.

 Proprietorships Advantages: Ease and low cost of formation. Disadvantages: Difficulty in

obtaining capital, limited life, unlimited liability.
 Partnerships Advantages: Ease and low cost of formation. Disadvantages: Unlimited
liability, limited life, difficulty in transferring ownership, difficulty in raising large
amounts of capital.
 Corporations Advantages: Limited liability, unlimited life, ease of ownership transfer,
ease of gaining capital. Disadvantages: double taxation, setup and filing reports.
 Limited Liability Corporations and Partnerships Advantages: Limited liability.
Disadvantages: Difficulty in raising capital, complex set up.
3. 1-7

Stockholder wealth maximization is a long-run goal. Companies, and consequently the

stockholders, prosper by management making decisions that will produce long-term earnings
increases. Actions that are continually shortsighted often "catch up" with a firm and, as a result, it
may find itself unable to compete effectively against its competitors. There has been much
criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the
U.S. auto industry, which has been accused of continuing to build large "gas guzzler" automobiles
because they had higher profit margins rather than retooling for smaller, more fuel-efficient
models.
4. What are the three basic areas in finance?

There are three basic areas in finance: Financial management (also called corporate finance) ,
Investment and Capital markets.
5. What are the four types of firms? What are advantages and disadvantages of each type?
Why do corporations dominate the economy?

Because corpo- rations conduct the most business and because most successful businesses
eventually convert to corporations.

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6. What are the financial decisions made by a manager of a firm? Give two examples of
each type.

The financial decisions made by a manager of a firm are Investing decisions, Financing decisions
and Dividend policy.
- Two examples of each type:

 Investing decisions: Company replaces old machines with new ones;

 Financing decisions: Company decided to borrow $3 million from a bank to finance its
expansion project;  Interest on borrowed funds have to be paid whether or not a firm has
made a profit.
 Dividend policies: Company decided to pay 40% of its earnings as cash dividend to its
shareholders;  If a company sets the payout rate at 6%, it is the percentage of profits that
will be paid out regardless of the amount of profits earned for the financial year. Whether
a company makes $1 million or $100,000, a fixed dividend will be paid out.
7. Distinguish between real assets and financial assets. Give two examples of each type.

- Real assets are goods (generally tangible) that are used to produce other goods or services:
buildings, machines, land, knowledge. Productivity of economy determined by real assets.
Financial assets are claims to income generated by real assets. Firms use the money raised
through financial assets to invest in plants, equipment, labour, etc. Holder of financial asset
receives a portion of the resulting returns from real assets. While real assets determine wealth,
financial assets determine distribution of wealth.
- Two examples of each type:

Real assets: Real Estate such as Land, residential, and commercial properties, including
REITs; Infrastructure such as Assets and networks used to transport, store and distribute,
such as toll roads, pipelines, airports, and cellphone towers.
 Financial assets: Cash and stocks.
8. What are the three critical factors in finance? Discuss the importance of these factors.

- 3 critical factors in finance are:

 Projected cash flows to shareholders (Return)

 Timing of the cash flow stream (Time)
 Riskiness of the cash flows (Risk)
9. What is the primary objective of corporate financial decision making?

The objective of decision making in corporate finance is to maximize firm value/stock prices.
10. What is agency problem? Why do they exist within a corporation? How to mitigate
agency problems?

An agency problem is a conflict of interest inherent in any relationship where one party is
expected to act in another's best interests. In corporate finance, an agency problem usually refers
to a conflict of interest between a company's management and the company's stockholders. The
manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that
will maximize shareholder wealth even though it is in the manager’s best interest to maximize
their own wealth. The agency problem arises due to an issue with incentives and the presence of
discretion in task completion. An agent may be motivated to act in a manner that is not favorable
for the principal if the agent is presented with an incentive to act in this way. While it is not
possible to eliminate the agency problem, principals can take steps to minimize the risk, known as
agency cost, associated with it. Principal-agent relationships can be regulated, and often are, by
contracts, or laws in the case of fiduciary settings. Another method is to incentivize an agent to
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 act in better accordance with the principal's best interests. For example, if an agent is paid not on
an hourly basis but by the completion of a project, there is less incentive to not act in the
principal’s best interest.
11. What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run
value more closely related to its intrinsic value or to its current price?

A firm's intrinsic value is an estimate of a stock's "true" value based on accurate risk and return
data. It can be estimated but not measured precisely. A stock's current price is its market price—
the value based on perceived but possibly incorrect information as seen by the marginal investor.
From these definitions, you can see that a stock's "true" long-run value is more closely related to
its intrinsic value rather than its current price.
Part 2 (tutorial 1)
1. Is an initial public offering an example of a primary or a secondary market transaction?
Explain

2. Indicate whether the following instruments are examples of money market or capital
market securities.
3. Describe the different ways in which capital can be transferred from suppliers of capital
to those who are demanding capital

- Direct transfers of money and securities occur when a business sells its stocks or bondsdirectly
to savers, without going through any type of financial institution. The businessdelivers its
securities to savers, who in turn give the firm the money it needs.
- Transfers may also go through an investment banking house which underwrites the issue.An
underwriter serves as a middleman and facilitates the issuance of securities. Thecompany sells its
stocks or bonds to the investment bank, which in turn sells these samesecurities to savers. The
businesses’ securities and the savers’ money merely “passthrough” the investment banking house.
- Transfers can also be made through a financial intermediary. Here the intermediaryobtains funds
from savers in exchange for its own securities. The intermediary uses thismoney to buy and hold
businesses’ securities. Intermediaries literally create new forms ofcapital. The existence of
intermediaries greatly increases the efficiency of money andcapital markets.
4. The president of Southern Semiconductor Corporation (SSC) made this statement in the
company’s annual report: “SSC’s primary goal is to increase the value of our common
stockholders’ equity.” Later in the report, the following announcements were made:
A. The company contributed $1.5 million to the symphony orchestra in Birmingham,
Alabama, its headquarters city.
B. The company is spending $500 million to open a new plant and expand operations in
China. No profits will be produced by the Chinese operation for 4 years, so earnings will
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 be depressed during this period versus what they would have been had the decision been
made not to expand in China.
C. The company holds about half of its assets in the form of U.S. Treasury bonds, and it
keeps these funds available for use in emergencies. In the future, though, SSC plans to
shift its emergency funds from Treasury bonds to common stocks.
Discuss how SSC’s stockholders might view each of these actions and how the actions
might affect the stock price.
1) Stockholders will not like this, it decreases money they could've used to increase the
stockholder value. 
Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to
create a more attractive community that will make it easier to hire a productive work force.
This corporate philanthropy could be received by stockholders negatively, especially those
stockholders not living in its headquarters city. Stockholders are interested in actions that
maximize share price, and if competing firms are not making similar contributions, the "cost"
of this philanthropy has to be borne by someone--the stockholders. Thus, stock price could
decrease. 

2) Companies must make investments in the current period in order to generate future cash
flows. Stockholders should be aware of this, and assuming a correct analysis has been
performed, they should react positively to the decision. The Chinese plant is in this category.
Capital budgeting is covered in depth in Part 4 of the text. Assuming that the correct capital
budgeting analysis has been made, the stock price should increase in the future.

3) U.S. Treasury bonds are considered safe investments, while common stocks are far more
risky. If the company were to switch the emergency funds from Treasury bonds to stocks,
stockholders should see this as increasing the firm's risk because stock returns are not
guaranteed—sometimes they increase and sometimes they decline. The firm might need the
funds when the prices of their investments were low and not have the needed emergency
funds. Consequently, the firm's stock price would probably fall.

Additional questions
1. Money markets are markets for:
a. Corporate stocks
b. Corporate long-term bonds
c. Short-term debt securities
d. Residential mortgages
2. Capital markets are markets for:
a. Commercial papers
b. Corporate long-term bonds
c. Short-term debt securities
d. Government bonds
3. Which of the followings is not a financial asset?
a. Stocks
b. Bonds
c. Property
d. Cash
4. Which of the following transactions takes place in secondary markets?
a. Listed stock bought by an investor on HSX
b. New stock sold in an IPO
c. New stock sold in an additional issue (seasoned equity offering)
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 d. New bond issued by a company.
5. When a corporation wants to raise funds by issuing new stocks or bonds, it generally uses
services of___
a. An investment banker
b. The State Securities Commission of Vietnam (SSC)
c. The Hanoi Stock Exchange (HNX)
d. The Ho Chi Minh Stock Exchange (HSX)
6. Which of the following is considered an organized stock exchange?
a. NASDAG
b. OTC
c. HSX
d. Both a. and b.
7. A market is said to be liquid if___
a. Investments can be turned into cash nearly immediately
b. Investments can be turned into liquid securities nearly immediately
c. Investments can be turned into cash easily and immediately
d. Investments can be turned into cash easily at a price which reflects fair value.
8. If you were able to prove that the market is week-form efficient, what would you conclude
from this?
a. Technical analysis (i.e. the use of chart to predict future stock movement) is a waste
of time.
b. Fundament analysis (i.e. the analysis based on fundamentals factors of a stock such as
EPS, P/E, ROE to find intrinsic value) is a waste of time
c. Insider trading is a waste of time
d. Both a. And b.
9. investors expect a company to announce a 10% increase in earnings; instead, the company
announces a 3% increase. If the market is semi-strong form efficient, which of the following
would you expect to happen?
a. The stock’s price will increase slightly because the company had a slight increase in
earnings.
b. The stock’s price will fall because the increase in earnings was less than expected.
c. The stock’s price will stay the same because earnings announcements have no effect
if the market is semi-strong form efficient.

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