SOLUTIONS MANUAL
FUNDAMENTALS OF INVESTING
14TH EDITION
CHAPTER NO. 1: THE INVESTMENT ENVIRONMENT
FAILURES IN FINANCE: CRITICAL THINKING QUESTION
The ability to borrow short-term funds at low interest rates was critical to Lehman
Brothers operations. By disguising these repurchase agreements as sales of assets rather
than very short-term loans, Lehman inflated revenues and made their balance sheet look
much stronger than it actually was. At this point in its history, Lehman was highly
leveraged and facing declining liquidity. The inability to obtain cheap, short-term loans
would mean the death of the company which, of course, did ensue. For the individuals
involved, large sums in the form of bonuses and investments in the firm were riding on
the firm’s survival. It might be worth mentioning that the practice was borderline
acceptable under British law, but it did not conform to U.S. GAAP.
ANSWERS TO CONCEPTS IN REVIEW
1.1 An investment is any asset into which funds can be placed with the expectation of
preserving or increasing value and earning a positive rate of return. An investment
can be a security or a property. Individuals invest because an investment has the
potential to preserve or increase value and to earn income. It is important to stress
that this does not imply that an investment will in fact preserve value or earn
income. Investing often involves taking risk, so an investment’s actual performance
will often differ from its expected performance.
1.2 (a) Securities and property are simply two classes of investments. Securities are
investments issued by firms, governments, or other organizations that represent a
legal claim on the resources of the issuer. For example, a bond represents a loan
that the borrower is legally obligated to repay, and a stock represents a
proportionate ownership in a firm. An option, on the other hand, represents
,the legal right to either buy or sell an asset at a predetermined price within a
specified time period. Property constitutes investments in either real property
(land and buildings) or tangible personal property (e.g., Rembrandt paintings,
Ming vases, or gold coins). These days, some students are likely to ask about
cryptocurrencies, which have characteristics of both transactional currencies and
speculative security investments.
(b) With a direct investment, an individual acquires a direct claim on a security or
property. For example, an investment in one share of IBM stock directly
provides the stockholder a proportionate ownership in IBM. An indirect
investment provides an indirect claim on a security or property. For example, if
you buy one share of Fidelity Growth Fund (a mutual fund) or an ETF that
tracks the S&P 500 index, you are in effect buying a portion of a portfolio of
securities owned by the fund. Thus, you will have a claim on a fraction of an
entire portfolio of securities. Many funds also invest in a variety of debt
instruments.
(c) An investment in debt represents funds loaned in exchange for the receipt of
interest income and repayment of the loan at a given future date. The bond, a
common debt instrument, pays specified interest over a specified time period,
then repays the face value of the loan. (Chapters 10 and 11 cover bonds in
detail.) An equity investment provides an investor an ongoing fractional
ownership interest in a firm. The most common example is an investment in a
company’s common stock. We will study equity instruments in greater detail in
Chapters 6 through 8. Derivative securities are securities derived from debt or
equity securities and structured to exhibit characteristics and value based upon
the underlying securities. Options are derivative securities that allow an investor
to sell or buy another security or asset at a specific price over a given time
period. For example, an investor might purchase an option to buy Facebook
stock for $50 within nine months.
(d) Short-term investments typically mature within one year while long-term
investments have longer maturities, including common stock, which has no
maturity at all. However, long-term investments can be used to satisfy short-term
, financial goals.
1.3 Investors expect to be paid for accepting risk. Low or no risk investments typically
offer low rates of return while riskier investments, meaning that returns are less
predictable, tend to offer potentially higher returns.
1.4 In finance, risk reflects the uncertainty surrounding the return that an investment
will generate. Risk refers to the chance that the return from an investment will differ
from its expected value. Low-risk investments are those considered safe with respect
to the return of funds invested and the receipt of a positive rate of return. High-risk
investments are those that have more uncertain future values and levels of earnings.
1.5 Foreign investments are investments in the debt, equity, derivative securities of
foreign-based companies, and property in a foreign country. Both direct and indirect
foreign investments sometimes provide investors more attractive returns or lower-
risk investments compared to purely domestic investments, but beyond that they are
useful instruments to diversify a purely domestic portfolio.
1.6 The investment process brings together suppliers and demanders of funds. This may
occur directly (as with property investments). More often the investment process is
aided by a financial institution (such as a bank, savings and loan, savings bank,
credit union, insurance company, or pension fund) that channels funds to
investments and/or a financial market (either the money market or the capital
market) where transactions occur between suppliers and demanders of funds.
1.7 (a) The various levels of government (federal, state, and local) generally require
more funds for projects and debt repayment than they receive in revenues.
Thus, governments are net demanders of funds. The term net refers to the fact that,
while governments both supply and demand funds in the investment process, on
balance they demand more than they supply.
(b) Businesses are also net demanders, requiring funds to cover short- and long-term
operating and investment (growth) needs. While business firms often supply
funds, on balance they also demand more than they supply.
(c) Individuals are the net suppliers of funds to the investment process. They put
more funds into the investment process than they take out. Individuals play an
, important role in the investment process—supplying the funds needed to finance
economic growth and development.
1.8 Institutional investors are investment professionals who are paid to manage other
people’s money. They are employed by financial institutions like banks and
insurance companies, by nonfinancial businesses, and by individuals. Individual
investors manage their own personal funds in order to meet their financial goals.
Generally, institutional investors tend to be more sophisticated because they handle
much larger amounts of money, and they tend to have a broader knowledge of the
investment process and available investment techniques.
1.9 Short-term investments usually have lives of less than one year. These investments
may be used to store temporarily idle funds until suitable long-term investments are
found. Due to their safety and convenience, they are popular with those who wish to
earn a return on temporarily idle funds or with the very conservative investor who
may use these short-term investments as a primary investment outlet. In addition to
their storage function, short-term investments provide liquidity—they can be
converted into cash quickly and with little or no loss in value. This characteristic is
very useful when investors need to meet unexpected expenses or take advantage of
attractive opportunities.
1.10 Common stock is an equity investment that represents a fractional ownership interest
in a corporation. The return on a common stock investment derives from two
sources: dividends, which are periodic payments made by the firm to its
shareholders from current and past earnings, and capital gains, which result from
selling the stock at a price above the original purchase price. Because common stock
offers a broad range of return-risk combinations, it is one of the most popular
investments s.
1.11 a. Bonds are debt obligations of corporations or governments. A bondholder
receives a stated interest return, typically semi-annually, plus the face value
at maturity. Bonds are usually issued in $1,000 denominations, pay semi-annual
interest, and have 10 - to 30- year maturities. Bonds offer fixed/certain returns, if
held until maturity.
FUNDAMENTALS OF INVESTING
14TH EDITION
CHAPTER NO. 1: THE INVESTMENT ENVIRONMENT
FAILURES IN FINANCE: CRITICAL THINKING QUESTION
The ability to borrow short-term funds at low interest rates was critical to Lehman
Brothers operations. By disguising these repurchase agreements as sales of assets rather
than very short-term loans, Lehman inflated revenues and made their balance sheet look
much stronger than it actually was. At this point in its history, Lehman was highly
leveraged and facing declining liquidity. The inability to obtain cheap, short-term loans
would mean the death of the company which, of course, did ensue. For the individuals
involved, large sums in the form of bonuses and investments in the firm were riding on
the firm’s survival. It might be worth mentioning that the practice was borderline
acceptable under British law, but it did not conform to U.S. GAAP.
ANSWERS TO CONCEPTS IN REVIEW
1.1 An investment is any asset into which funds can be placed with the expectation of
preserving or increasing value and earning a positive rate of return. An investment
can be a security or a property. Individuals invest because an investment has the
potential to preserve or increase value and to earn income. It is important to stress
that this does not imply that an investment will in fact preserve value or earn
income. Investing often involves taking risk, so an investment’s actual performance
will often differ from its expected performance.
1.2 (a) Securities and property are simply two classes of investments. Securities are
investments issued by firms, governments, or other organizations that represent a
legal claim on the resources of the issuer. For example, a bond represents a loan
that the borrower is legally obligated to repay, and a stock represents a
proportionate ownership in a firm. An option, on the other hand, represents
,the legal right to either buy or sell an asset at a predetermined price within a
specified time period. Property constitutes investments in either real property
(land and buildings) or tangible personal property (e.g., Rembrandt paintings,
Ming vases, or gold coins). These days, some students are likely to ask about
cryptocurrencies, which have characteristics of both transactional currencies and
speculative security investments.
(b) With a direct investment, an individual acquires a direct claim on a security or
property. For example, an investment in one share of IBM stock directly
provides the stockholder a proportionate ownership in IBM. An indirect
investment provides an indirect claim on a security or property. For example, if
you buy one share of Fidelity Growth Fund (a mutual fund) or an ETF that
tracks the S&P 500 index, you are in effect buying a portion of a portfolio of
securities owned by the fund. Thus, you will have a claim on a fraction of an
entire portfolio of securities. Many funds also invest in a variety of debt
instruments.
(c) An investment in debt represents funds loaned in exchange for the receipt of
interest income and repayment of the loan at a given future date. The bond, a
common debt instrument, pays specified interest over a specified time period,
then repays the face value of the loan. (Chapters 10 and 11 cover bonds in
detail.) An equity investment provides an investor an ongoing fractional
ownership interest in a firm. The most common example is an investment in a
company’s common stock. We will study equity instruments in greater detail in
Chapters 6 through 8. Derivative securities are securities derived from debt or
equity securities and structured to exhibit characteristics and value based upon
the underlying securities. Options are derivative securities that allow an investor
to sell or buy another security or asset at a specific price over a given time
period. For example, an investor might purchase an option to buy Facebook
stock for $50 within nine months.
(d) Short-term investments typically mature within one year while long-term
investments have longer maturities, including common stock, which has no
maturity at all. However, long-term investments can be used to satisfy short-term
, financial goals.
1.3 Investors expect to be paid for accepting risk. Low or no risk investments typically
offer low rates of return while riskier investments, meaning that returns are less
predictable, tend to offer potentially higher returns.
1.4 In finance, risk reflects the uncertainty surrounding the return that an investment
will generate. Risk refers to the chance that the return from an investment will differ
from its expected value. Low-risk investments are those considered safe with respect
to the return of funds invested and the receipt of a positive rate of return. High-risk
investments are those that have more uncertain future values and levels of earnings.
1.5 Foreign investments are investments in the debt, equity, derivative securities of
foreign-based companies, and property in a foreign country. Both direct and indirect
foreign investments sometimes provide investors more attractive returns or lower-
risk investments compared to purely domestic investments, but beyond that they are
useful instruments to diversify a purely domestic portfolio.
1.6 The investment process brings together suppliers and demanders of funds. This may
occur directly (as with property investments). More often the investment process is
aided by a financial institution (such as a bank, savings and loan, savings bank,
credit union, insurance company, or pension fund) that channels funds to
investments and/or a financial market (either the money market or the capital
market) where transactions occur between suppliers and demanders of funds.
1.7 (a) The various levels of government (federal, state, and local) generally require
more funds for projects and debt repayment than they receive in revenues.
Thus, governments are net demanders of funds. The term net refers to the fact that,
while governments both supply and demand funds in the investment process, on
balance they demand more than they supply.
(b) Businesses are also net demanders, requiring funds to cover short- and long-term
operating and investment (growth) needs. While business firms often supply
funds, on balance they also demand more than they supply.
(c) Individuals are the net suppliers of funds to the investment process. They put
more funds into the investment process than they take out. Individuals play an
, important role in the investment process—supplying the funds needed to finance
economic growth and development.
1.8 Institutional investors are investment professionals who are paid to manage other
people’s money. They are employed by financial institutions like banks and
insurance companies, by nonfinancial businesses, and by individuals. Individual
investors manage their own personal funds in order to meet their financial goals.
Generally, institutional investors tend to be more sophisticated because they handle
much larger amounts of money, and they tend to have a broader knowledge of the
investment process and available investment techniques.
1.9 Short-term investments usually have lives of less than one year. These investments
may be used to store temporarily idle funds until suitable long-term investments are
found. Due to their safety and convenience, they are popular with those who wish to
earn a return on temporarily idle funds or with the very conservative investor who
may use these short-term investments as a primary investment outlet. In addition to
their storage function, short-term investments provide liquidity—they can be
converted into cash quickly and with little or no loss in value. This characteristic is
very useful when investors need to meet unexpected expenses or take advantage of
attractive opportunities.
1.10 Common stock is an equity investment that represents a fractional ownership interest
in a corporation. The return on a common stock investment derives from two
sources: dividends, which are periodic payments made by the firm to its
shareholders from current and past earnings, and capital gains, which result from
selling the stock at a price above the original purchase price. Because common stock
offers a broad range of return-risk combinations, it is one of the most popular
investments s.
1.11 a. Bonds are debt obligations of corporations or governments. A bondholder
receives a stated interest return, typically semi-annually, plus the face value
at maturity. Bonds are usually issued in $1,000 denominations, pay semi-annual
interest, and have 10 - to 30- year maturities. Bonds offer fixed/certain returns, if
held until maturity.
