, Chapter 1: An Introduction to Finance
Multiple Choice Questions
1. Section: 1.1 Finance Defined
Learning objective: 1.1
Level of Difficulty: Basic
Solution: A
2. Section: 1.2 Real versus Financial Assets
Learning objective: 1.2
Level of Difficulty: Intermediate
Solution: C
Stocks are financial assets. Examples of real assets are residential structures, non-residential
structures, machinery and equipment, durables, inventories, and land.
3. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Basic
Solution: B
4. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Intermediate
Solution: A
In the financial system, households are the primary fund providers to the government and
businesses.
5. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Intermediate
Solution: C
Banks, pension funds, and insurance firms do transform the nature of their underlying financial
securities. However, mutual funds do not transform the nature of the underlying financial
securities.
6. Section: 1.4 Financial Instruments and Markets
Learning objective: 1.4
Level of Difficulty: Intermediate
Solution: C
7. Section 1.5 The Global Financial Community
Learning objective: 1.5
Level of Difficulty: Intermediate
Solution: C
8. Section 1.5 The Global Financial Community
,Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Learning objective: 1.5
Level of Difficulty: Intermediate
Solution: D
Practice Problems
Intermediate
9. Section: 1.2 Real versus Financial Assets
Learning objective: 1.2
Level of Difficulty: Intermediate
Solution:
Balance sheet:
Residential structures: $1,000+ $3,000+$1,500 = $5,500
As there are no foreign assets or liabilities, the net worth or equity of the island is $5,500
To deal with Fred and Robinson’s debts:
Assets Liabilities
Fred
House $1,000
Debt to Friday $500
Robinson
House 3,000
Debt to Friday 2,000
Friday
House 1,500
Loan to Fred 500
Loan to Robinson 2,000
Totals $8,000 $2,500
As net worth equals assets minus liabilities, the net worth of the economy equals total assets
minus total liabilities or $5,500.
10. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Intermediate
Solution: In the financial system, there are mainly four major sectors: Households, Government,
Business, and Non-Residents. Within the field of finance there are four major areas: personal
finance, government finance, corporate finance, and international finance. They closely
interrelate to each other. Because they are all major parts of the whole financial system, what
happens in one market will affect all the other markets.
11. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Intermediate
Solution: Banks take in deposits and loan them out to fund borrowers. Pension funds take in
pension contributions and pay out pensions to plan participants when they retire. Insurance firms
, Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
take in premiums and pay out when a certain event occurs. Mutual funds pool small funds
together and make investments that small investors cannot make. Mutual funds also offer
investment expertise to ordinary investors.
12. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Intermediate
Solution: Five main reasons why financial and market intermediaries exist are:
i) They provide anonymousness and convenience to all transaction parties.
ii) They efficiently match the needs of the participants in the financial market and aggregate all
the small transactions.
iii) They have procedures for documentation of legal contracts to ensure security.
iv) The risk of non-payment is alleviated by maintaining credit ratings and by controlling other
accounts.
v) Financial institutions transform the nature of the underlying financial securities.
13. Section: 1.3 The Financial System
Learning objective: 1.3
Level of Difficulty: Intermediate
Solution: A “credit crunch” refers to a situation when financial intermediaries such as banks and
other lenders are either unable or unwilling, in general, to offer credit to borrowers. The crunch
usually arises due to a lack of confidence, leading people and other institutions to be unwilling to
lend to the financial intermediary. If very few people are willing to lend to the financial
intermediary, then they, in turn, will not have the funds available to lend out and the “crunch”
begins.
14. Section: 1.4 Financial Instruments and Markets
Learning objective: 1.4
Level of Difficulty: Intermediate
Solution: There are two major types of secondary markets are exchanges or auction markets and
dealer or over-the-counter (OTC) markets. Exchanges have been referred to as auction markets
because they involve a bidding process that takes place in a specific location (i.e., similar to an
auction). OTC or dealer markets do not have a physical location, but rather consist of a network
of dealers who trade directly with one another.
Challenging
15. Section: 1.4 Financial Instruments and Markets
Learning objective: 1.4
Level of Difficulty: Challenging
Solution: Secondary market transactions are those where ownership of existing shares changes
hands, but the corporations or governments who originally issued the securities receive no
financing; trading takes place between investors. This is critical to the functioning of the primary
markets, because governments and companies would not be able to raise financing if investors
were unable to sell their investments if necessary.
