FINS1612 Chapter 4: Viney8e_IRM_ch04

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Financial Institutions, Instruments and Markets

8th edition

Instructor's Resource Manual

Christopher Viney and Peter Phillips

Chapter 4

The share market and the corporation

Learning objective 4.1: understand the structure of a corporation and identify advantages and

disadvantages of being a publicly listed corporation

• Members of the board of directors of a corporation are elected by shareholders at a

general meeting.

• The board determines the objectives and policies of the firm, and appoints executive

managers, who are responsible for managing the day-to-day business operations and

reporting back to the board.

• With a limited liability company, the liability of a shareholder is limited to the fully paid

issue price of the shares.

• With a no liability company a shareholder holding any partly paid shares cannot be forced

to make further payment, but may forfeit the shares.

• Advantages of the corporate form of business include access to a large pool of equity

funds through the stock market, the separation of ownership (shareholders) and control

(managers), the continuity of business operations, the ability to conduct large-scale

operations and the opportunity for investors to hold a diversified share portfolio.

• A potential disadvantage of the corporate form is the agency problem, whereby managers

may try to run the business for their own benefit rather than for the shareholders’ benefit.

• The board of directors should establish strong corporate governance practices to ensure

accountability and transparency.

Learning objective 4.2: consider the origins and purpose of a stock exchange

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• The origins of stock exchanges date back to 1553 in England.

• Today, stock exchanges compete within the international markets where there are

continuous flows of information.

• A stock exchange facilitates the listing of corporations and the quotation and buying and

selling of listed securities.

• An exchange operates a securities trading system and a transaction settlement system.

• Stock exchanges, and regulators, seek to maintain the efficiency and integrity of the

market.

Learning objective 4.3: understand the primary market role of a stock exchange through which

corporations raise new funding

• The primary market role of a stock exchange relates to the issue of new securities by

listed corporations or other entities.

• The listing of a new company is known as a float or an initial public offering (IPO).

• The main form of equity issued by a corporation is the ordinary share (common stock).

• Primary market issues of ordinary shares raise equity capital for corporations. Equity

capital is typically used to enable a firm to grow.

• Shareholders may receive dividends and/or capital gains (or losses).

• Existing corporations may issue additional equity through rights issues, placements and

dividend reinvestment schemes.

• A stock exchange may also list debt instruments, units in public trusts and derivative

products.

• An issue of equity or debt to the public requires the preparation of a prospectus.

• The ASX, as at 3 April, had 2183 listed corporations and was ranked 8th in the MSCI

global index ranking.

Learning objective 4.4: discuss the secondary market role of the stock exchange through which

existing securities are bought and sold

• The secondary market role provides a market structure for the buying and selling of

existing listed securities.

• Buy and sell orders are lodged through a stockbroker that has access to the exchange’s

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trading and settlement platforms.

• Secondary market transactions do not raise additional equity for the original issuing

corporation—they are a transfer of ownership for value.

• Market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market

encourages investors.

• Market capitalisation is the number of issued shares multiplied by the share price.

Learning objective 4.5: examine the managed products (exchange traded funds, contracts for

difference, real estate investment trusts and infrastructure funds) and derivative products

(options, warrants and futures contracts) roles of a stock exchange

• Stock exchanges may list a range of managed products and derivative products. These

standardised products are known as exchange traded contracts.

• Exchange traded funds (ETF) usually invest in a basket of securities listed on the local or

international exchanges, foreign currencies or commodities. ETFs provide access to a

diversified portfolio of securities.

• A contract for difference (CFD) is an agreement to exchange the net difference in value

between the start date and the close date of a CFD. The CFD is based on a specified

security. Only a deposit is paid initially therefore the CFD is highly leveraged (increased

risk).

• A real estate investment trust (REIT) issues units in the trust in order to raise funds to

purchase property, including industrial, hotels and leisure, retail and office. Assets

generate rental income and (hopefully) capital gains.

• Infrastructure funds enable investors to gain access to large-scale infrastructure projects,

such as utilities, transport, materials handling and communications facilities.

• An option contract gives the buyer the right, but not the obligation, to buy (call option) or

sell (put option) a specified security at a predetermined price and date. The writer of the

option receives a premium payment from the option buyer.

• An equity warrant gives the holder the right to buy (or sell) the underlying security at a

specified price on or before a nominated date. Stock exchanges list a wide range of

warrant contracts.

• A futures contract is an agreement between two parties to buy (or sell) a specified

commodity or financial instrument at a specified date in the future. The value of the

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Document Summary

Learning objective 4. 2: consider the origins and purpose of a stock exchange. 2 trading and settlement platforms: secondary market transactions do not raise additional equity for the original issuing corporation they are a transfer of ownership for value, market liquidity is the ratio of turnover to market capitalisation. A deep and liquid market encourages investors: market capitalisation is the number of issued shares multiplied by the share price. These standardised products are known as exchange traded contracts: exchange traded funds (etf) usually invest in a basket of securities listed on the local or international exchanges, foreign currencies or commodities. Etfs provide access to a diversified portfolio of securities: a contract for difference (cfd) is an agreement to exchange the net difference in value between the start date and the close date of a cfd. The cfd is based on a specified security. Assets generate rental income and (hopefully) capital gains.

Related Questions

1) The subarea of finance where you need to value uncertain cash flows occurring at different points in time is:

a. investments

b. corporate finance

c. capital markets

d. bank management.

e. all of the above subareas

2) Which of the following statements is correct?

a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.

b. Corporations face fewer regulations than sole proprietorships.

c. One disadvantage of operating a business as a sole proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the Owner level.

d. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents ace required.

e. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

3) Which of the following statements is correct?

a. Corporations generally face fewer regulations than sole proprietorships.

b. Corporate shareholders are exposed to unlimited liability.

c. It is usually easier to transfer ownership in a corporation than in a partnership.

d. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

e. Less of a corporation's income is generally subject to federal taxes.

4) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to:

a. Maximize its expected total corporate income.

b. Maximize its expected EPS.

c. Minimize the chances of losses.

d. Maximize the stock price per share over the long run, which is the stockâs intrinsic value.

e. Maximize the stock price on a specific target date.

5) Which of the following is correct?

a. In most corporations, the CFO ranks above the CEO.

b. By Law in most states, the chairman of the board must also be the CEO.

c. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.

d. The CFO generally reports to the firm's chief accounting officer, who is normally the controller.

e. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.

6) The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to

a. Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth.

b. Maximize the firmâs expected EPS, which must also maximize the firmâs price per share.

c. Minimize the firmâs risks because most stockholders dislike risk in turn, this will maximize the firmâs stock price.

d. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.

e. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value.

7) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders?

a. Compensating managers with stock options.

b. Financing risky projects with additional debt.

c. The threat of hostile takeovers.

d. The use of covenants in bond agreements that limit the firmâs use of additional debt and constrain managers' actions.

e. Abolishing the Security and Exchange Commission.

8) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers?

a. Pay managers large cash salaries and give them no stock options.

b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

c. Beef up the restrictive covenants in the firmâs debt agreements.

d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firmâs stock.

e. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold.

9) Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?

a. Decrease the use of restrictive covenants in bond agreements.

b. Take actions that reduce the possibility of a hostile takeover.

c. Elect a board of directors tlta.t allows managers greater freedom of action.

d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

e. Eliminate a requirement that members of the board of directors have a substantial investment in the firmâs stock.

10) Which of the following is correct?

a. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock.

b. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects.

c. There is no good reason to expect a firmâs stockholders and bondholders to react differently to the types of assets in which it invests.

d. Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

e. Bondholders should generally be happier titan stockholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

11) You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?

a. This is an example of a direct transfer of capital

b. This is an example of a primary market transaction.

c. This is an example of an exchange of physical assets.

d. This is an example of a money market transaction.

e. This is an example of a derivative market transaction.

12) Which of the following statements is correct?

a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically.

b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift.

c. Capital market instruments include both long-term debt and common stocks.

d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.

e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

13) Which of the following is a primary market transaction?

a. You sell 200 shares of IBM stock on the NYSE through your broker.

b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker--you just give him cash and he gives you the stock.

c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker.

d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.

e. IBM sells 2,000.000 shares of treasury stock to its employees when they exercise options that were granted in prior years.

14) Money Markets are markets for:

a. Foreign currencies.

b. Consumer automobile loans.

c. Common stocks.

d. Long-term bonds.

e. Short-term debt securities such as Treasury bills and commercial paper.

15) You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of:

a. A money market transaction.

b. A primary market transaction.

c. A secondary market transaction.

d. A futures market transaction.

e. An over-the-counter market transaction.

16) Which of the following statements is correct?

a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United States.

b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia.

c. Hedge funds have more in common with investment banks than with any other type of financial institution.

d. Hedge funds have more in common with commercial banks than with any other type of financial institution.

e. Hedge funds are not as highly regulated as most other types of financial institutions.

17) Which of the following factors statements is correct?

a. The New York Stock Exchange is an auction market, and it has a physical location.

b. Home mortgage loans are traded in the money market.

c. If an investor sells shares of stock through a broker, then it would be a primary market transaction.

d. Capital markets deal only with common stocks and other equity securities.

e. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

18) Which of the following statements is correct?

a. The term "IPO" stands for Introductory Price Offered, and it is the price at which shares of a new company are offered to the public.

b. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day the stock is offered to the public.

c. In a "Dutch auction," investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay.

d. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed.

e. It is possible that the price set in an IPO is so low that investors will want to buy more shares than the company wants to sell. In that case, the company will have to issue more shares than it wants to sell.

19) The stock market is thought to be efficient because:

a. There are many brokers working the exchange floors

b. Computers can make very fast calculations these days

c. There are many stock analysts following the same stocks

d. Stocks are available and are very inexpensive

e. Speed trading is now an acceptable trading technique

20) If the stock is priced correctly but with better management the firm could be worth even more, then the firm would be:

a. A potential target for a stock investor

b. A potential target for a private equity firm

c. A potential target for a bond fund

d. A potential target for the SEC

e. A potential target for share repurchases

FINS1612 Chapter 4: Viney8e_IRM_ch04

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