CHAPTER 1: THE INVESTMENT ENVIRONMENT

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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 (or increase, depending on the strategy) volatility by hedging sources of risk more efficiently.

Estimated Time: 1–5 min

2.Securitization requires access to many 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 (and make for) a well-developed capital market.

Estimated Time: 1–5 min

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, financial intermediaries lose opportunities; they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business as well as other financial services.

Estimated Time: 1–5 min

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CHAPTER 1: THE INVESTMENT ENVIRONMENT

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• 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. Suppose Ford or Amazon could not issue stocks or bonds to the public, it would far more difficult raising capital. Contraction of the supply of financial assets and access to that supply would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital results in less investment and lower real growth.

Estimated Time: 1–5 min

• 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 and ultimately the decisions of the managers. For example, if the stock price rises considerably, managers might conclude that the market believes the firm’s 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. Firms can raise capital quickly in primary markets because investors know there are liquid secondary markets.

Estimated Time: 1–5 min

6.

• No. The increase in price did not add to the productive capacity of the economy.
• Yes, the value of the equity held in these assets has increased.
• Future homeowners 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.

Estimated Time: 1–5 min 2 / 4

CHAPTER 1: THE INVESTMENT ENVIRONMENT

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7.

• 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.

• 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.

• Lanni exchanges the real asset (the software) for a financial asset, which is 1,250

shares of Microsoft stock. If Microsoft issues new shares to pay Lanni, then this represents the creation of new financial assets.

• 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.

Estimated Time: 1–5 min

8.a.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 assets to total assets $30,000 $100,000==0.30

b.Assets Liabilities & 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.Assets Liabilities & Shareholders’ Equity

Microsoft shares $125,000 Bank loan $ 50,000 Computers 30,000 Shareholders’ equity 105,000 Total $155,000 Total $155,000 3 / 4

CHAPTER 1: THE INVESTMENT ENVIRONMENT

1-4 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.Ratio of real assets to total assets $30,000 $155,000==0.19

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.

Estimated Time: 1–5 min

9.

a. For commercial banks, the ratio is: $191.9 / $22,564.2=0.0085 or 0.85%.

b. For nonfinancial firms, the ratio is: $25,974 / $50,856=0.5107 or 51.07%.

• The difference should be expected primarily because the bulk of the business of

financial institutions is to make loans and the bulk of the business of nonfinancial corporations is to invest in equipment, manufacturing plants, and property. The loans are financial assets for financial institutions, but the investments of nonfinancial corporations are real assets.

Estimated Time: 1–5 min

10.

• Primary market transaction in which gold certificates are being offered to public

investors for the first time by an underwriting syndicate led by JW Korth Capital.

• The certificates are derivative assets because while represent an investment in

physical gold, each investor receives a certificate and no gold. Note that investors can convert the certificate into gold during the 4-year period. The security’s value is derived from gold.

Estimated Time: 1–5 min

11.

• A fixed salary means that compensation is, 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, so a manager might not feel too compelled to work hard to maximize firm value. 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. Five years of vesting helps align the interests of the employee with the long-term performance of the firm. This structure is therefore most likely to align the interests of managers and shareholders. If stock compensation is overdone, however, the manager might view

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