SOLUTIONS MANUAL
ESSENTIALS OF INVESTMENTS
2024 RELEASE EVERGREEN RELEASE
CHAPTER 01: INVESTMENTS: BACKGROUND AND ISSUES
1. Equity is a lower-priority claim on earnings (expressed as dividends) that represents an
ownership share in a corporation. Fixed-income (debt) security is a higher-priority
claim that legally obligates the issuer to pay the holder of the debt but does not have an
ownership interest. Fixed-income securities typically pay a specified cash flow at pre-
contracted time intervals until the last payment on the maturity date. Shares of equity
have an indefinite life.
2. A primary (financial) asset has a claim on the real assets of a firm, whereas a derivative
asset provides a payoff that depends on the prices of a primary asset but does not
include the claim on the real assets.
3. Asset allocation is the allocation of an investment portfolio across broad asset classes.
Security selection is the choice of specific securities within each asset class.
4. Agency problems are conflicts of interest between managers and stockholders. They
can be addressed through corporate governance mechanisms, such as the design of
executive compensation, oversight by the Board, and monitoring from the institutional
investors.
5. Real assets have productive capacity; they are assets used to produce goods and
services. Real assets can be tangible (e.g., machinery) or intangible (e.g., a patent).
Financial assets are claims on real assets or the income generated by them.
,6. Investment bankers are firms specializing in the sale of new securities to the public,
typically by underwriting the issue. Commercial banks accept deposits and lend the
money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some
commercial banks started transforming to “universal banks” which provide the services
of both commercial banks and investment banks. With the passage of the Dodd–Frank
Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially
restored via the Volcker Rule (which generally prohibits commercial banks from
conducting certain investment activities with their own accounts and investing in hedge
funds and private equity funds). In 2018, Congress passed The Economic Growth,
Regulatory Relief, and Consumer Protection Act established a threshold ($10 billion)
for banks to be exempt from the Volcker Rule.
7. Financial and Real Assets
a. Toyota creates a real asset—the factory. The loan is a financial asset that is created
in the transaction.
b. When the loan is repaid, the financial asset is destroyed but the real asset continues
to exist.
c. The cash is a financial asset that is traded in exchange for a real asset, inventory.
8. Real Estate as a Real Asset
a. No. The real estate in existence has not changed, only the perception of its value
has.
b. Yes. The financial asset value of the claims on the real estate has changed, and thus
the balance sheet of individual investors has been reduced.
c. The difference between these two answers reflects the difference between real and
financial asset values. Real assets still exist, yet the value of the claims on those assets
or the cash flows they generate do change. Thus, there is the difference.
9. Real and Financial Assets
a. The bank loan is a financial liability for Lanni. Lanni's $50,000 IOU is the bank's
financial asset. The cash Lanni receives is a financial asset. The new financial asset
created is Lanni's promissory note held by the bank.
, b. The cash paid by Lanni (both the loan and its own cash) is the transfer of a financial
asset to the software developer. In return, Lanni gets a real asset, the completed
software. No financial assets are created or destroyed. Cash is simply transferred from
one firm to another.
c. Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni
receives a financial asset, 500 shares of Microsoft stock. If Microsoft issues new shares
in order to pay Lanni, that would be the creation of a new financial asset.
d. In selling 500 shares of stock for $125,000, Lanni is exchanging one financial asset
for another. In paying off the IOU with $50,000, Lanni is exchanging financial assets.
The loan is "destroyed" in the transaction since it is retired when paid.
10.
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
$30,000
Ratio of real to total assets = = 0.3
$100,000
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
*Value at cost
$100,000
Ratio of real to total assets = = 1.0
$100,000
, c.
Assets Liabilities &
Microsoft shares ($250/share) $125,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 105,000
Total $155,000 Total $155,000
$30,000
Ratio of real to total assets = = 0.19
$155,000
Conclusion: When the firm starts up and raises working capital, it will be characterized
by a low ratio of real to total assets. When it is in full production, it will have a high
ratio of real assets. When the project "shuts down" and the firm sells it, the percentage
of real assets to total assets goes down again because the product is again exchanged
into financial assets.
11. Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act
proposed several mechanisms to mitigate systemic risk. The act attempts to limit the
risky activities in which the banks can engage and calls for stricter rules for bank
capital, liquidity, and risk management practices, especially as banks become larger and
their potential failure becomes more threatening to other institutions. The act seeks to
unify and clarify the lines of regulatory authority and responsibility in government
agencies and to address the incentive issue by forcing employee compensation to reflect
longer-term performance. It also mandates increased transparency, especially in
derivatives markets. In 2018, Congress passed The Economic Growth, Regulatory
Relief, and Consumer Protection Act, exempting most small to medium-sized banks
from the Dodd-Frank rules, including stress tests.
$190.7
12. a. For commercial banks, the ratio is: = 0.0080
$23,727.5
$29,273
b. For non-financial firms, the ratio is: = 0.5344
$54,777
c. The difference should be expected since the business of financial institutions is to
make loans that are financial assets.
ESSENTIALS OF INVESTMENTS
2024 RELEASE EVERGREEN RELEASE
CHAPTER 01: INVESTMENTS: BACKGROUND AND ISSUES
1. Equity is a lower-priority claim on earnings (expressed as dividends) that represents an
ownership share in a corporation. Fixed-income (debt) security is a higher-priority
claim that legally obligates the issuer to pay the holder of the debt but does not have an
ownership interest. Fixed-income securities typically pay a specified cash flow at pre-
contracted time intervals until the last payment on the maturity date. Shares of equity
have an indefinite life.
2. A primary (financial) asset has a claim on the real assets of a firm, whereas a derivative
asset provides a payoff that depends on the prices of a primary asset but does not
include the claim on the real assets.
3. Asset allocation is the allocation of an investment portfolio across broad asset classes.
Security selection is the choice of specific securities within each asset class.
4. Agency problems are conflicts of interest between managers and stockholders. They
can be addressed through corporate governance mechanisms, such as the design of
executive compensation, oversight by the Board, and monitoring from the institutional
investors.
5. Real assets have productive capacity; they are assets used to produce goods and
services. Real assets can be tangible (e.g., machinery) or intangible (e.g., a patent).
Financial assets are claims on real assets or the income generated by them.
,6. Investment bankers are firms specializing in the sale of new securities to the public,
typically by underwriting the issue. Commercial banks accept deposits and lend the
money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some
commercial banks started transforming to “universal banks” which provide the services
of both commercial banks and investment banks. With the passage of the Dodd–Frank
Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially
restored via the Volcker Rule (which generally prohibits commercial banks from
conducting certain investment activities with their own accounts and investing in hedge
funds and private equity funds). In 2018, Congress passed The Economic Growth,
Regulatory Relief, and Consumer Protection Act established a threshold ($10 billion)
for banks to be exempt from the Volcker Rule.
7. Financial and Real Assets
a. Toyota creates a real asset—the factory. The loan is a financial asset that is created
in the transaction.
b. When the loan is repaid, the financial asset is destroyed but the real asset continues
to exist.
c. The cash is a financial asset that is traded in exchange for a real asset, inventory.
8. Real Estate as a Real Asset
a. No. The real estate in existence has not changed, only the perception of its value
has.
b. Yes. The financial asset value of the claims on the real estate has changed, and thus
the balance sheet of individual investors has been reduced.
c. The difference between these two answers reflects the difference between real and
financial asset values. Real assets still exist, yet the value of the claims on those assets
or the cash flows they generate do change. Thus, there is the difference.
9. Real and Financial Assets
a. The bank loan is a financial liability for Lanni. Lanni's $50,000 IOU is the bank's
financial asset. The cash Lanni receives is a financial asset. The new financial asset
created is Lanni's promissory note held by the bank.
, b. The cash paid by Lanni (both the loan and its own cash) is the transfer of a financial
asset to the software developer. In return, Lanni gets a real asset, the completed
software. No financial assets are created or destroyed. Cash is simply transferred from
one firm to another.
c. Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni
receives a financial asset, 500 shares of Microsoft stock. If Microsoft issues new shares
in order to pay Lanni, that would be the creation of a new financial asset.
d. In selling 500 shares of stock for $125,000, Lanni is exchanging one financial asset
for another. In paying off the IOU with $50,000, Lanni is exchanging financial assets.
The loan is "destroyed" in the transaction since it is retired when paid.
10.
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
$30,000
Ratio of real to total assets = = 0.3
$100,000
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
*Value at cost
$100,000
Ratio of real to total assets = = 1.0
$100,000
, c.
Assets Liabilities &
Microsoft shares ($250/share) $125,000 Bank loan $50,000
Computers 30,000 Shareholders’ equity 105,000
Total $155,000 Total $155,000
$30,000
Ratio of real to total assets = = 0.19
$155,000
Conclusion: When the firm starts up and raises working capital, it will be characterized
by a low ratio of real to total assets. When it is in full production, it will have a high
ratio of real assets. When the project "shuts down" and the firm sells it, the percentage
of real assets to total assets goes down again because the product is again exchanged
into financial assets.
11. Passed in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act
proposed several mechanisms to mitigate systemic risk. The act attempts to limit the
risky activities in which the banks can engage and calls for stricter rules for bank
capital, liquidity, and risk management practices, especially as banks become larger and
their potential failure becomes more threatening to other institutions. The act seeks to
unify and clarify the lines of regulatory authority and responsibility in government
agencies and to address the incentive issue by forcing employee compensation to reflect
longer-term performance. It also mandates increased transparency, especially in
derivatives markets. In 2018, Congress passed The Economic Growth, Regulatory
Relief, and Consumer Protection Act, exempting most small to medium-sized banks
from the Dodd-Frank rules, including stress tests.
$190.7
12. a. For commercial banks, the ratio is: = 0.0080
$23,727.5
$29,273
b. For non-financial firms, the ratio is: = 0.5344
$54,777
c. The difference should be expected since the business of financial institutions is to
make loans that are financial assets.
