Question

a. Compare the financial institutions that act as brokers to those that act as a transformer

of assets. Give any three examples for these two types of financial institutions and

describe how they function as a financial intermediary.

b. If a sizeable technology firm ‘Nortus’ wants to raise US$10 mil to expand its operations describe three options so that the firm can raise the funds either through direct financing or indirect financing. Compare the pros and cons of these options.

Answer 1

a) Financial institutions act as intermediaries between savers and borrowers and they direct the flow of funds between them. With funds deposited by savers in checking, savings, and money market accounts, they make loans to individual and commercial borrowers.

Two types of financial institutions are:

1) Depository institutions: banks that accept deposits. Examples are commercial banks, savings banks, and credit unions.

2) Nondepository institutions: These institutions provide financial services but don’t accept deposits.

Examples are finance companies, insurance companies, brokerage firms, and pension funds.

Financial intermediaries move funds from parties with excess capital to parties needing funds. The process creates efficient markets and lowers the cost of conducting business. Banks connect borrowers and lenders by providing capital from other financial institutions and from the Federal Reserve. Insurance companies collect premiums for policies and provide policy benefits.

b) Firm can raise the funds either through direct financing.

Information, Risk, and Insurance, is a situation where buyers and sellers in a market do not both have full and equal information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.

Any young startup firm is a risk, some startup firms are only a little more than an idea on paper. The firm’s founders inevitably have better information about how hard they are willing to work, and whether the firm is likely to succeed, than anyone else. When the founders put their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to overcome the imperfect information, at least in part, by knowing the managers and their business plan personally and by giving them advice.

Pros and cons are 1) Direct financing discourages hard work whereas indirect financing does not discouarge effort.

2)Direct financing is cheap and easy to collect whereas indirect financing difficult and costly to collect.