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1:39:29 PM
CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. Ultimately, it is true that real assets determine the material well being of an
economy. Nevertheless, individuals can benefit when financial engineering creates
new products that allow them to manage their portfolios of financial assets more
efficiently. Because bundling and unbundling creates financial products with new
properties and sensitivities to various sources of risk, it allows investors to hedge
particular sources of risk more efficiently.
2. Securitization requires access to a large number of potential investors. To attract
these investors, the capital market needs:
1. a safe system of business laws and low probability y of confiscato
confiscator
confiscatory
taxation/regulation;
2. a well-developed investmentt banking industry;
ind
3. a well-developed system off brokerage and
and financial
ial transactions,
tran
transac and;
4. well-developed media,, particularly financial
finan
fi ial reporting.
ancial
These characteristics are
re found in (indeed
deed make for) a well-developed
(inde w financial
market.
3. Securitization leads to disintermediation;
rmediation; that
ntermediation; th is, securitization provides a means
for market participants to bypass intermediaries.
interm
interme For example, mortgage-backed
securities channel fundsnds to the housing
hous market without requiring that banks or
thrift institutions make
akee loans
loan from their own portfolios. As securitization
progresses, financial
ancial
ial intermediaries
intermediar
intermedi must increase other activities such as
term liquidity
providing short-term liquidi to consumers and small business, and financial
services.
4. Financial assets make it easy for large firms to raise the capital needed to finance
their investments in real assets. If Ford, for example, could not issue stocks or
bonds to the general public, it would have a far more difficult time raising capital.
Contraction of the supply of financial assets would make financing more difficult,
thereby increasing the cost of capital. A higher cost of capital results in less
investment and lower real growth.
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1:39:29 PM
5. Even if the firm does not need to issue stock in any particular year, the stock market
is still important to the financial manager. The stock price provides important
information about how the market values the firm's investment projects. For example,
if the stock price rises considerably, managers might conclude that the market
believes the firm's future prospects are bright. This might be a useful signal to the
firm to proceed with an investment such as an expansion of the firm's business.
In addition, shares that can be traded in the secondary market are more attractive to
initial investors since they know that they will be able to sell their shares. This in
turn makes investors more willing to buy shares in a primary offering, and thus
improves the terms on which firms can raise money in the equity market.
6. a. No. The increase in price did not add to the productive capacity of the
economy.
b. Yes, the value of the equity held in these assets has increased.
ased.
c. Future homeowners as a whole are worse off, since mortgage rtgage liabil
liabili
liabilities have
also increased. In addition, this housing
using
sing pri
pprice bubblele will
ll eventua
eventually burst and
society as a whole (and most likely
ely
ly taxpayers)
taxpayers w will
ill endure
dure the dam
damage.
7. nancial
cial liability fo
a. The bank loan is a financial ffor Lanni.
anni. (Lann
(Lanni's IOU is the bank's
financial asset.) The cash
ash Lanni receivivess is a financia
receives financ
financial asset. The new financial
ni's
i's promissoryy nnote
asset created is Lanni's te (that is, Lanni’s
La
L IOU to the bank).
cial as
b. Lanni transfers financial assets
ts (cash) to th
the software developers. In return,
Lanni gets a real asset, thee completed softw
so
software. No financial assets are created or
ply transferred
destroyed; cash is simply ransferred from
fro one party to another.
c. Lanni gives thee real
eal asset (t
(the ssoftware) to Microsoft in exchange for a financial
ares
es of Micros
asset, 1,500 shares Microsoft stock. If Microsoft issues new shares in order to
pay Lanni, then this
his would
woul represent
r the creation of new financial assets.
d. Lanni exchanges one financial asset (1,500 shares of stock) for another
nges on
($120,000). Lanni gives a financial asset ($50,000 cash) to the bank and gets back
another financial asset (its IOU). The loan is "destroyed" in the transaction, since it
is retired when paid off and no longer exists.
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1:39:29 PM
8. a.
Liabilities &
Assets
Shareholders’ equity
Cash $ 70,000 Bank loan $ 50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
Ratio of real assets to total assets = $30,000/$100,000 = 0.30
b.
Liabilities &
Assets
Shareholders’ equity
Software product* $ 70,000 Bank loan $ 50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
*Valued at cost
Ratio of real assets to total assets = $100,000/$100,000 = 1.0
c.
Liabilities
ilities &
Assets
Shareholders’
Sh
hareholders’
reholders’ eequ
equity
Microsoft shares $120,000
120,000 Bank
B k loan $ 50,000
Computers 30,000 Shareholders’
Sh
hareholders’
eholders’ equ
equity 100,000
Total $150,000 Total $150,000
Ratio of real assets to
o total assets = $30,000/$150
$30,000/$150,
$30,000/$150,000 = 0.20
Conclusion: when the firm m star
starts
arts up and raises
rais working capital, it is characterized by
a low ratio of real assets to total assets. WWhen it is in full production, it has a high
Wh
ratio of real assets to total
al assets
assets.. Whe
When the project "shuts down" and the firm sells it
off for cash, financiall assets
ts once aaga
again replace real assets.
9. For commercial
ciall banks, the ratio is: $140.1/$11,895.1 = 0.0118
th ra
For non-financial
ncial
cial firms,
firm tthe ratio is: $12,538/$26,572 = 0.4719
The difference should
hould be expected primarily because the bulk of the
business of financial institutions is to make loans; which are financial assets
for financial institutions.
10. a. Primary-market transaction
b. Derivative assets
c. Investors who wish to hold gold without the complication and cost of
physical storage.
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1:39:29 PM
11. a. A fixed salary means that compensation is (at least in the short run)
independent of the firm's success. This salary structure does not tie the manager’s
immediate compensation to the success of the firm. However, the manager might
view this as the safest compensation structure and therefore value it more highly.
b. A salary that is paid in the form of stock in the firm means that the manager earns
the most when the shareholders’ wealth is maximized. Five years of vesting helps
align the interests of the employee with the long-term performance of the firm. This
structure is therefore most likely to align the interests of managers and shareholders.
If stock compensation is overdone, however, the manager might view it as overly
risky since the manager’s career is already linked to the firm, and this undiversified
exposure would be exacerbated with a large stock position in the firm.
c. A profit-linked salary creates great incentives for managers to contribute to the
firm’s success. However, a manager whose salary is tied to short-term profits will be
risk seeking, especially if these short-term profits determine salary or if the
compensation structure does not bear the full cost of the project’s
ject’s ris
rrisks. Shareholders,
in contrast, bear the losses as well as the gains on the project,
roject, might be less
ject, and mig
willing to assume that risk.
12. Even if an individual shareholder
holder
older could mmon
monitor
nitor
or and improv
impro
improve managers’ performance,
and thereby increase the value firm,
lue of the firm
m, the would be small, since the
he payoff wo
ownership share in a large
arge corporationn would
ould be ver
very small. For example, if you own
$10,000 of Ford stock
ckk and can increase
crease
ease the value oof the firm by 5%, a very ambitious
goal, you benefit by only
nly:: 0.05 $10,000
only: 10,000 = $5$500
In contrast, a bank that has a multimillion
multimillion-dollar
ultimillion-do loan outstanding to the firm has a big
stake in making sure thatt the firm can rrep
repay the loan. It is clearly worthwhile for the
bank to spend considerable
erablee resources tto monitor the firm.
13. Mutual fundsds accept funds fro
ffrom small investors and invest, on behalf of these
investors, in the national an
and international securities markets.
Pension funds accept
ccept fu
funds and then invest, on behalf of current and future retirees,
thereby channeling funds from one sector of the economy to another.
Venture capital firms pool the funds of private investors and invest in start-up firms.
Banks accept deposits from customers and loan those funds to businesses, or use the
funds to buy securities of large corporations.
14. Treasury bills serve a purpose for investors who prefer a low-risk investment.
The lower average rate of return compared to stocks is the price investors pay
for predictability of investment performance and portfolio value.
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1:39:29 PM
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1:39:29 PM
CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. Ultimately, it is true that real assets determine the material well being of an
economy. Nevertheless, individuals can benefit when financial engineering creates
new products that allow them to manage their portfolios of financial assets more
efficiently. Because bundling and unbundling creates financial products with new
properties and sensitivities to various sources of risk, it allows investors to hedge
particular sources of risk more efficiently.
2. Securitization requires access to a large number of potential investors. To attract
these investors, the capital market needs:
1. a safe system of business laws and low probability y of confiscato
confiscator
confiscatory
taxation/regulation;
2. a well-developed investmentt banking industry;
ind
3. a well-developed system off brokerage and
and financial
ial transactions,
tran
transac and;
4. well-developed media,, particularly financial
finan
fi ial reporting.
ancial
These characteristics are
re found in (indeed
deed make for) a well-developed
(inde w financial
market.
3. Securitization leads to disintermediation;
rmediation; that
ntermediation; th is, securitization provides a means
for market participants to bypass intermediaries.
interm
interme For example, mortgage-backed
securities channel fundsnds to the housing
hous market without requiring that banks or
thrift institutions make
akee loans
loan from their own portfolios. As securitization
progresses, financial
ancial
ial intermediaries
intermediar
intermedi must increase other activities such as
term liquidity
providing short-term liquidi to consumers and small business, and financial
services.
4. Financial assets make it easy for large firms to raise the capital needed to finance
their investments in real assets. If Ford, for example, could not issue stocks or
bonds to the general public, it would have a far more difficult time raising capital.
Contraction of the supply of financial assets would make financing more difficult,
thereby increasing the cost of capital. A higher cost of capital results in less
investment and lower real growth.
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1:39:29 PM
5. Even if the firm does not need to issue stock in any particular year, the stock market
is still important to the financial manager. The stock price provides important
information about how the market values the firm's investment projects. For example,
if the stock price rises considerably, managers might conclude that the market
believes the firm's future prospects are bright. This might be a useful signal to the
firm to proceed with an investment such as an expansion of the firm's business.
In addition, shares that can be traded in the secondary market are more attractive to
initial investors since they know that they will be able to sell their shares. This in
turn makes investors more willing to buy shares in a primary offering, and thus
improves the terms on which firms can raise money in the equity market.
6. a. No. The increase in price did not add to the productive capacity of the
economy.
b. Yes, the value of the equity held in these assets has increased.
ased.
c. Future homeowners as a whole are worse off, since mortgage rtgage liabil
liabili
liabilities have
also increased. In addition, this housing
using
sing pri
pprice bubblele will
ll eventua
eventually burst and
society as a whole (and most likely
ely
ly taxpayers)
taxpayers w will
ill endure
dure the dam
damage.
7. nancial
cial liability fo
a. The bank loan is a financial ffor Lanni.
anni. (Lann
(Lanni's IOU is the bank's
financial asset.) The cash
ash Lanni receivivess is a financia
receives financ
financial asset. The new financial
ni's
i's promissoryy nnote
asset created is Lanni's te (that is, Lanni’s
La
L IOU to the bank).
cial as
b. Lanni transfers financial assets
ts (cash) to th
the software developers. In return,
Lanni gets a real asset, thee completed softw
so
software. No financial assets are created or
ply transferred
destroyed; cash is simply ransferred from
fro one party to another.
c. Lanni gives thee real
eal asset (t
(the ssoftware) to Microsoft in exchange for a financial
ares
es of Micros
asset, 1,500 shares Microsoft stock. If Microsoft issues new shares in order to
pay Lanni, then this
his would
woul represent
r the creation of new financial assets.
d. Lanni exchanges one financial asset (1,500 shares of stock) for another
nges on
($120,000). Lanni gives a financial asset ($50,000 cash) to the bank and gets back
another financial asset (its IOU). The loan is "destroyed" in the transaction, since it
is retired when paid off and no longer exists.
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1:39:29 PM
8. a.
Liabilities &
Assets
Shareholders’ equity
Cash $ 70,000 Bank loan $ 50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
Ratio of real assets to total assets = $30,000/$100,000 = 0.30
b.
Liabilities &
Assets
Shareholders’ equity
Software product* $ 70,000 Bank loan $ 50,000
Computers 30,000 Shareholders’ equity 50,000
Total $100,000 Total $100,000
*Valued at cost
Ratio of real assets to total assets = $100,000/$100,000 = 1.0
c.
Liabilities
ilities &
Assets
Shareholders’
Sh
hareholders’
reholders’ eequ
equity
Microsoft shares $120,000
120,000 Bank
B k loan $ 50,000
Computers 30,000 Shareholders’
Sh
hareholders’
eholders’ equ
equity 100,000
Total $150,000 Total $150,000
Ratio of real assets to
o total assets = $30,000/$150
$30,000/$150,
$30,000/$150,000 = 0.20
Conclusion: when the firm m star
starts
arts up and raises
rais working capital, it is characterized by
a low ratio of real assets to total assets. WWhen it is in full production, it has a high
Wh
ratio of real assets to total
al assets
assets.. Whe
When the project "shuts down" and the firm sells it
off for cash, financiall assets
ts once aaga
again replace real assets.
9. For commercial
ciall banks, the ratio is: $140.1/$11,895.1 = 0.0118
th ra
For non-financial
ncial
cial firms,
firm tthe ratio is: $12,538/$26,572 = 0.4719
The difference should
hould be expected primarily because the bulk of the
business of financial institutions is to make loans; which are financial assets
for financial institutions.
10. a. Primary-market transaction
b. Derivative assets
c. Investors who wish to hold gold without the complication and cost of
physical storage.
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1:39:29 PM
11. a. A fixed salary means that compensation is (at least in the short run)
independent of the firm's success. This salary structure does not tie the manager’s
immediate compensation to the success of the firm. However, the manager might
view this as the safest compensation structure and therefore value it more highly.
b. A salary that is paid in the form of stock in the firm means that the manager earns
the most when the shareholders’ wealth is maximized. Five years of vesting helps
align the interests of the employee with the long-term performance of the firm. This
structure is therefore most likely to align the interests of managers and shareholders.
If stock compensation is overdone, however, the manager might view it as overly
risky since the manager’s career is already linked to the firm, and this undiversified
exposure would be exacerbated with a large stock position in the firm.
c. A profit-linked salary creates great incentives for managers to contribute to the
firm’s success. However, a manager whose salary is tied to short-term profits will be
risk seeking, especially if these short-term profits determine salary or if the
compensation structure does not bear the full cost of the project’s
ject’s ris
rrisks. Shareholders,
in contrast, bear the losses as well as the gains on the project,
roject, might be less
ject, and mig
willing to assume that risk.
12. Even if an individual shareholder
holder
older could mmon
monitor
nitor
or and improv
impro
improve managers’ performance,
and thereby increase the value firm,
lue of the firm
m, the would be small, since the
he payoff wo
ownership share in a large
arge corporationn would
ould be ver
very small. For example, if you own
$10,000 of Ford stock
ckk and can increase
crease
ease the value oof the firm by 5%, a very ambitious
goal, you benefit by only
nly:: 0.05 $10,000
only: 10,000 = $5$500
In contrast, a bank that has a multimillion
multimillion-dollar
ultimillion-do loan outstanding to the firm has a big
stake in making sure thatt the firm can rrep
repay the loan. It is clearly worthwhile for the
bank to spend considerable
erablee resources tto monitor the firm.
13. Mutual fundsds accept funds fro
ffrom small investors and invest, on behalf of these
investors, in the national an
and international securities markets.
Pension funds accept
ccept fu
funds and then invest, on behalf of current and future retirees,
thereby channeling funds from one sector of the economy to another.
Venture capital firms pool the funds of private investors and invest in start-up firms.
Banks accept deposits from customers and loan those funds to businesses, or use the
funds to buy securities of large corporations.
14. Treasury bills serve a purpose for investors who prefer a low-risk investment.
The lower average rate of return compared to stocks is the price investors pay
for predictability of investment performance and portfolio value.
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