Chapter 16, Problem 2ST

For the example below, list and describe the input(s) (observable or unobservable) and valuation technique(s) used. Determine the appropriate classification in the fair value hierarchy. Company A invested in the common stock of a private furniture manufacturer, Company Z. Quoted prices are not available for Company Z’s stock. Company Z’s fair value is measured as the present value of future cash flow. The measurement requires management assumptions such as discount rate, the amount and the timing of future cash flow.

1. Refers to the inability of the business to meet its obligations as they mature on account of insufficient resources. A. Default risk B. Interest-rate risk C. Purchasing power risk D. Liquidity risk   2. A type of risk that relates to changes in the prime interest rate which have significant effects on the cost of money but not directly on the liquidity of the business. A. Financial risk B. Interest-rate risk C. Purchasing power risk D. Liquidity risk   3. Refers to the changes in the conditions and those variables affecting the cost of capital, capital structure and also management decisions made to directly influence the market price of a stock. A. Financial risk B. Interest-rate risk C. Purchasing power risk D. Liquidity risk

Discuss the concepts of adverse selection and moral hazard. Provide an example of each of these problems in financial markets and explain how these problems affect the financial structure and the rate of economic growth.