Solutions Manual
Investments, 13th Edition by Zvi Bodie, Alex Kane, Alan J. Marcus.
ISBN13: 9781264412662
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 of confiscatory
taxation/regulation;
(2) a well-developed investment banking industry;
(3) a well-developed system of brokerage and financial transactions, and;
(4) well-developed media, particularly financial reporting.
These characteristics are found in (indeed make for) a well-developed financial market.
3. Securitization leads to disintermediation; that is, securitization provides a means for
market participants to bypass intermediaries. For example, mortgage-backed securities
channel funds to the housing market without requiring that banks or thrift institutions
make loans from their own portfolios. As securitization progresses, financial
intermediaries must increase other activities such as providing short-term liquidity 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 General Motors, 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.
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, the fact that shares can be traded in the secondary market makes the shares
more attractive to investors since investors know that, when they wish to, 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. Cash is a financial asset because it is the liability of the federal government.
b. No. The cash does not directly add to the productive capacity of the economy.
c. Yes.
d. Society as a whole is worse off, since taxpayers, as a group will make up for the
liability.
7. a. The bank loan is a financial liability for Lanni. (Lanni's 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 (that is, Lanni’s IOU to the bank).
b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni
gets a real asset, the completed software. No financial assets are created or
destroyed; cash is simply transferred from one party to another.
c. Lanni gives the real asset (the software) to Microsoft in exchange for a financial
asset, 1,500 shares of Microsoft stock. If Microsoft issues new shares in order to pay
Lanni, then this would represent the creation of new financial assets.
d. Lanni exchanges one financial asset (1,500 shares of stock) for another ($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.
,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 &
Assets
Shareholders’ equity
Microsoft shares $120,000 Bank loan $ 50,000
Computers 30,000 Shareholders’ equity 100,000
Total $150,000 Total $150,000
Ratio of real assets to total assets = $30,000/$150,000 = 0.20
Conclusion: when the firm starts up and raises working capital, it is characterized by
a low ratio of real assets to total assets. When it is in full production, it has a high
ratio of real assets to total assets. When the project "shuts down" and the firm sells it
off for cash, financial assets once again replace real assets.
9. For commercial banks, the ratio is: $107.5/$10,410.9 = 0.010
For non-financial firms, the ratio is: $13,295/$25,164 = 0.528
The difference should 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.
, 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. 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. Call options on shares of the firm create great incentives for managers to contribute to
the firm’s success. In some cases, however, stock options can lead to other agency
problems. For example, a manager with numerous call options might be tempted to
take on a very risky investment project, reasoning that if the project succeeds the
payoff will be huge, while if it fails, the losses are limited to the lost value of the
options. Shareholders, in contrast, bear the losses as well as the gains on the project,
and might be less willing to assume that risk.
12. Even if an individual shareholder could monitor and improve managers’ performance, and
thereby increase the value of the firm, the payoff would be small, since the ownership share
in a large corporation would be very small. For example, if you own $10,000 of GM stock
and can increase the value of the firm by 5%, a very ambitious goal, you benefit by only:
0.05 $10,000 = $500
In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake
in making sure that the firm can repay the loan. It is clearly worthwhile for the bank to
spend considerable resources to monitor the firm.
13. Mutual funds accept funds from small investors and invest, on behalf of these investors,
in the national and international securities markets.
Pension funds accept 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.
Investments, 13th Edition by Zvi Bodie, Alex Kane, Alan J. Marcus.
ISBN13: 9781264412662
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 of confiscatory
taxation/regulation;
(2) a well-developed investment banking industry;
(3) a well-developed system of brokerage and financial transactions, and;
(4) well-developed media, particularly financial reporting.
These characteristics are found in (indeed make for) a well-developed financial market.
3. Securitization leads to disintermediation; that is, securitization provides a means for
market participants to bypass intermediaries. For example, mortgage-backed securities
channel funds to the housing market without requiring that banks or thrift institutions
make loans from their own portfolios. As securitization progresses, financial
intermediaries must increase other activities such as providing short-term liquidity 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 General Motors, 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.
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, the fact that shares can be traded in the secondary market makes the shares
more attractive to investors since investors know that, when they wish to, 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. Cash is a financial asset because it is the liability of the federal government.
b. No. The cash does not directly add to the productive capacity of the economy.
c. Yes.
d. Society as a whole is worse off, since taxpayers, as a group will make up for the
liability.
7. a. The bank loan is a financial liability for Lanni. (Lanni's 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 (that is, Lanni’s IOU to the bank).
b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni
gets a real asset, the completed software. No financial assets are created or
destroyed; cash is simply transferred from one party to another.
c. Lanni gives the real asset (the software) to Microsoft in exchange for a financial
asset, 1,500 shares of Microsoft stock. If Microsoft issues new shares in order to pay
Lanni, then this would represent the creation of new financial assets.
d. Lanni exchanges one financial asset (1,500 shares of stock) for another ($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.
,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 &
Assets
Shareholders’ equity
Microsoft shares $120,000 Bank loan $ 50,000
Computers 30,000 Shareholders’ equity 100,000
Total $150,000 Total $150,000
Ratio of real assets to total assets = $30,000/$150,000 = 0.20
Conclusion: when the firm starts up and raises working capital, it is characterized by
a low ratio of real assets to total assets. When it is in full production, it has a high
ratio of real assets to total assets. When the project "shuts down" and the firm sells it
off for cash, financial assets once again replace real assets.
9. For commercial banks, the ratio is: $107.5/$10,410.9 = 0.010
For non-financial firms, the ratio is: $13,295/$25,164 = 0.528
The difference should 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.
, 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. 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. Call options on shares of the firm create great incentives for managers to contribute to
the firm’s success. In some cases, however, stock options can lead to other agency
problems. For example, a manager with numerous call options might be tempted to
take on a very risky investment project, reasoning that if the project succeeds the
payoff will be huge, while if it fails, the losses are limited to the lost value of the
options. Shareholders, in contrast, bear the losses as well as the gains on the project,
and might be less willing to assume that risk.
12. Even if an individual shareholder could monitor and improve managers’ performance, and
thereby increase the value of the firm, the payoff would be small, since the ownership share
in a large corporation would be very small. For example, if you own $10,000 of GM stock
and can increase the value of the firm by 5%, a very ambitious goal, you benefit by only:
0.05 $10,000 = $500
In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake
in making sure that the firm can repay the loan. It is clearly worthwhile for the bank to
spend considerable resources to monitor the firm.
13. Mutual funds accept funds from small investors and invest, on behalf of these investors,
in the national and international securities markets.
Pension funds accept 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.
