CHAPTER 1: THE INVESTMENT ENVIRONMENT
CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. While it is ultimately true that real assets determine the material well-being of an
economy, financial innovation in the form of bundling and unbundling securities
creates opportunities for investors to form more efficient portfolios. Both
institutional and individual investors can benefit when financial engineering creates
new products that allow them to manage their portfolios of financial assets more
efficiently. Bundling and unbundling create financial products with new properties
and sensitivities to various sources of risk that allows investors to reduce volatility
by hedging 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. Securitization works well
and can benefit many, but only if the market for these securities is highly liquid.
As securitization progresses, however, and financial intermediaries lose
opportunities, they must increase other revenue-generating activities such as
providing short-term liquidity to consumers and small business and financial
services.
4. The existence of efficient capital markets and the liquid trading of 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.
1-1
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McGraw-Hill Education.
, CHAPTER 1: THE INVESTMENT ENVIRONMENT
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.
Remember that stock exchanges like those in New York, London, and Paris are the
heart of capitalism, in which firms can raise capital quickly in primary markets
because investors know there are liquid secondary markets.
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.
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 suffer the damage.
7. a. The bank loan is a financial liability for Lanni, and a financial asset for the bank.
The cash Lanni receives is a financial asset. The new financial asset created is
Lanni's promissory note to repay the loan.
b. Lanni transfers financial assets (cash) to the software developers. In return,
Lanni receives the completed software package, which is a real asset. No
financial assets are created or destroyed; cash is simply transferred from one party
to another.
c. Lanni exchanges the real asset (the software) for a financial asset, which is 1,250
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. By selling its shares in Microsoft, Lanni exchanges one financial asset (1,250
shares of stock) for another ($125,000 in cash). Lanni uses the financial asset of
$50,000 in cash to repay the bank and retire its promissory note. The bank must
return its financial asset to Lanni. The loan is "destroyed" in the transaction, since it
is retired when paid off and no longer exists.
1-2
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1. While it is ultimately true that real assets determine the material well-being of an
economy, financial innovation in the form of bundling and unbundling securities
creates opportunities for investors to form more efficient portfolios. Both
institutional and individual investors can benefit when financial engineering creates
new products that allow them to manage their portfolios of financial assets more
efficiently. Bundling and unbundling create financial products with new properties
and sensitivities to various sources of risk that allows investors to reduce volatility
by hedging 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. Securitization works well
and can benefit many, but only if the market for these securities is highly liquid.
As securitization progresses, however, and financial intermediaries lose
opportunities, they must increase other revenue-generating activities such as
providing short-term liquidity to consumers and small business and financial
services.
4. The existence of efficient capital markets and the liquid trading of 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.
1-1
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
, CHAPTER 1: THE INVESTMENT ENVIRONMENT
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.
Remember that stock exchanges like those in New York, London, and Paris are the
heart of capitalism, in which firms can raise capital quickly in primary markets
because investors know there are liquid secondary markets.
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.
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 suffer the damage.
7. a. The bank loan is a financial liability for Lanni, and a financial asset for the bank.
The cash Lanni receives is a financial asset. The new financial asset created is
Lanni's promissory note to repay the loan.
b. Lanni transfers financial assets (cash) to the software developers. In return,
Lanni receives the completed software package, which is a real asset. No
financial assets are created or destroyed; cash is simply transferred from one party
to another.
c. Lanni exchanges the real asset (the software) for a financial asset, which is 1,250
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. By selling its shares in Microsoft, Lanni exchanges one financial asset (1,250
shares of stock) for another ($125,000 in cash). Lanni uses the financial asset of
$50,000 in cash to repay the bank and retire its promissory note. The bank must
return its financial asset to Lanni. The loan is "destroyed" in the transaction, since it
is retired when paid off and no longer exists.
1-2
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
