CHAPTER 1: THE INVESTMENT ENVIRONMENT

1. a. b. c. d. Cash is a financial asset because it is the liability of the federal government. No. The cash does not directly add to the productive capacity of the economy. Yes. Society as a whole is worse off, since taxpayers, as a group will make up for the liability. 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, Lannis IOU to the bank). 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. 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. 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.

2.

a.

b.

c.

d.

3.

a. 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 = 0.30 Assets b. Assets Software product* Computers Total *Valued at cost Ratio of real to total assets = $100,000/$100,000 = 1.0 $ 70,000 30,000 $100,000 Liabilities & Shareholders equity Bank loan $ 50,000 Shareholders equity 50,000 Total $100,000

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c. Assets Microsoft shares Computers Total $120,000 30,000 $150,000 Liabilities & Shareholders equity Bank loan $ 50,000 Shareholders equity 100,000 Total $150,000

Ratio of real to total assets = $30,000/$150,000 = 0.20 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. Ultimately, it is true that real assets do 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. For commercial banks, the ratio is: $94.2/$8,480.5 = 0.011 For non-financial firms, the ratio is: $10,973/$21,851 = 0.502 The difference should be expected primarily because the bulk of the business of financial institutions is to make loans that are financial assets. a. b. c. Primary-market transaction Derivative assets. Investors who wish to hold gold without the complication and cost of physical storage. 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 managers 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. 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 managers career is already linked to the firm, and this undiversified exposure would be exacerbated with a large stock position in the firm.

5.

6.

7.

a.

b.

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Call options on shares of the firm create great incentives for managers to contribute to the firms 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.

8.

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.

9.

Securitization requires access to a large number of potential investors. To attract these investors, the capital market needs: (1) (2) (3) (4) a safe system of business laws and low probability of confiscatory taxation/regulation; a well-developed investment banking industry; a well-developed system of brokerage and financial transactions, and; well-developed media, particularly financial reporting.

These characteristics are found in (indeed make for) a well-developed financial market. 10. 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. 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 means less investment and lower real growth.

11.

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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.

13.

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.

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. With a top-down investment strategy, you focus on asset allocation or the broad composition of the entire portfolio, which is the major determinant of overall performance. Moreover, top down management is the natural way to establish a portfolio with a level of risk consistent with your risk tolerance. The disadvantage of an exclusive emphasis on top down issues is that you may forfeit the potential high returns that could result from identifying and concentrating in undervalued securities or sectors of the market. With a bottom-up investment strategy, you try to benefit from identifying undervalued securities. The disadvantage is that you tend to overlook the overall composition of your portfolio, which may result in a non-diversified portfolio or a portfolio with a risk level inconsistent with your level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, your analysis may be incorrect, in which case you will have fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy.

15.

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You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would then be so ready to sell the secret to others. Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and obvious bargains are few and far between. Odds are that the only one getting rich from the book is its author. a. The SEC website defines the difference between saving and investing in terms of the investment alternatives or the financial assets the individual chooses to acquire. According to the SEC website, saving is the process of acquiring a safe financial asset and investing is the process of acquiring risky financial assets. The economists definition of savings is the difference between income and consumption. Investing is the process of allocating ones savings among available assets, both real assets and financial assets. The SEC definitions actually represent (according the economists definition) two kinds of investment alternatives.

17.

b.

18.

As is the case for the SEC definitions (see Problem 17), the SIA defines saving and investing as acquisition of alternative kinds of financial assets. According to the SIA, saving is the process of acquiring safe assets, generally from a bank, while investing is the acquisition of other financial assets, such as stocks and bonds. On the other hand, the definitions in the chapter indicate that saving means spending less than ones income. Investing is the process of allocating ones savings among financial assets, including savings account deposits and money market accounts (saving according to the SIA), other financial assets such as stocks and bonds (investing according to the SIA), as well as real assets.

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