CHAPTER 1
THE INVESTMENT ENVIRONMENT
1. 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 doubled.
c. Future homeowners as a whole are worse off, since mortgage liabilities have
also increased. In addition, this housing price bubble will eventually burst and
society as a whole (and most likely taxpayers) will endure the damage.
2. 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 (i.e., 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 stock in Microsoft. If Microsoft issues new shares in order
to pay Lanni, only then would this 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.
3. a. Lanni’s Balance Sheet
(after bank loan)
Assets Liabilities & 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 to total assets = $30,000/$100,000 = .30.
, b. Lanni’s Balance Sheet
(after development of product)
Assets Liabilities & Shareholders’ Equity
Cash $ 5,000 Bank loan $ 50,000
Software product* 65,000 Shareholders’ equity 50,000
Computers 30,000
Total $100,000 Total $100,000
*Valued at cost.
Ratio of real to total assets = $95,000/$100,000 = .95.
c. Lanni’s Balance Sheet
(after accepting payment of shares)
Assets Liabilities & Shareholders’ equity
Cash $ 5,000 Bank loan $ 50,000
Microsoft shares $120,000 Shareholders’ equity 105,000
Computers 30,000
Total $155,000 Total $155,000
Ratio of real to total assets = $30,000/$155,000 = .19.
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 off for cash, financial assets once again replace real assets.
4. 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 channelling
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.
5. Securitization requires access to a large number of potential investors. To attract
them 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 information systems, particularly for financial
reporting. These are found in (indeed make for) a well-developed financial market.
6. 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.
7. Securitization leads to disintermediation; that is, it 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.
8. The REIT manager pools the resources of many investors and uses these resources
to buy a portfolio of real estate assets. Each investor in the REIT owns a fraction of
the total portfolio, in accordance with the size of the individual investment. The
REIT gives the investor the ability to hold a diversified portfolio of real estate assets.
Moreover, the investor has the ability to buy and sell shares of the REIT far more
easily and cheaply than the underlying real estate itself could be bought or sold.
Investors are willing to pay the manager of a REIT a reasonable management fee in
return for these benefits. Therefore, the profit motive will lead qualified firms to
organize and sell REITs.
9. Ultimately, real assets do determine the material well-being of an economy.
Nevertheless, individuals can benefit when financial engineering creates new
products that allow investors to manage their portfolios of financial assets more
efficiently. Because bundling and unbundling creates financial products with new
properties and differing sensitivities to various sources of risk, financial engineering
allows investors to allocate and hedge particular sources of risk more efficiently.
10. Financial assets make it easy for large firms to raise capital to finance their
investments in real assets. If CP, 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, increasing the
cost of capital. A higher cost of capital means less investment and lower real growth.
11. In nineteenth-century America, with its largely agrarian economy, uncertainty in
crop yields and prices was a major source of economywide risk. Therefore, there
was a great incentive to create mechanisms to allow both producers and purchasers
of agricultural commodities to hedge this risk. In contrast, the uncertainty of paper
or pencil prices was far smaller, and the need to hedge against such risk was
minimal. There would be no demand for trading in securities that would allow
investors to transfer risk in the prices of these goods.
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 percent,
a very ambitious goal, you benefit by only (.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. 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.
14. a. Primary-market transaction
b. Derivative assets
THE INVESTMENT ENVIRONMENT
1. 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 doubled.
c. Future homeowners as a whole are worse off, since mortgage liabilities have
also increased. In addition, this housing price bubble will eventually burst and
society as a whole (and most likely taxpayers) will endure the damage.
2. 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 (i.e., 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 stock in Microsoft. If Microsoft issues new shares in order
to pay Lanni, only then would this 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.
3. a. Lanni’s Balance Sheet
(after bank loan)
Assets Liabilities & 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 to total assets = $30,000/$100,000 = .30.
, b. Lanni’s Balance Sheet
(after development of product)
Assets Liabilities & Shareholders’ Equity
Cash $ 5,000 Bank loan $ 50,000
Software product* 65,000 Shareholders’ equity 50,000
Computers 30,000
Total $100,000 Total $100,000
*Valued at cost.
Ratio of real to total assets = $95,000/$100,000 = .95.
c. Lanni’s Balance Sheet
(after accepting payment of shares)
Assets Liabilities & Shareholders’ equity
Cash $ 5,000 Bank loan $ 50,000
Microsoft shares $120,000 Shareholders’ equity 105,000
Computers 30,000
Total $155,000 Total $155,000
Ratio of real to total assets = $30,000/$155,000 = .19.
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 off for cash, financial assets once again replace real assets.
4. 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 channelling
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.
5. Securitization requires access to a large number of potential investors. To attract
them 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 information systems, particularly for financial
reporting. These are found in (indeed make for) a well-developed financial market.
6. 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.
7. Securitization leads to disintermediation; that is, it 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.
8. The REIT manager pools the resources of many investors and uses these resources
to buy a portfolio of real estate assets. Each investor in the REIT owns a fraction of
the total portfolio, in accordance with the size of the individual investment. The
REIT gives the investor the ability to hold a diversified portfolio of real estate assets.
Moreover, the investor has the ability to buy and sell shares of the REIT far more
easily and cheaply than the underlying real estate itself could be bought or sold.
Investors are willing to pay the manager of a REIT a reasonable management fee in
return for these benefits. Therefore, the profit motive will lead qualified firms to
organize and sell REITs.
9. Ultimately, real assets do determine the material well-being of an economy.
Nevertheless, individuals can benefit when financial engineering creates new
products that allow investors to manage their portfolios of financial assets more
efficiently. Because bundling and unbundling creates financial products with new
properties and differing sensitivities to various sources of risk, financial engineering
allows investors to allocate and hedge particular sources of risk more efficiently.
10. Financial assets make it easy for large firms to raise capital to finance their
investments in real assets. If CP, 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, increasing the
cost of capital. A higher cost of capital means less investment and lower real growth.
11. In nineteenth-century America, with its largely agrarian economy, uncertainty in
crop yields and prices was a major source of economywide risk. Therefore, there
was a great incentive to create mechanisms to allow both producers and purchasers
of agricultural commodities to hedge this risk. In contrast, the uncertainty of paper
or pencil prices was far smaller, and the need to hedge against such risk was
minimal. There would be no demand for trading in securities that would allow
investors to transfer risk in the prices of these goods.
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 percent,
a very ambitious goal, you benefit by only (.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. 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.
14. a. Primary-market transaction
b. Derivative assets
