Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis Portfolio

Investment Analysis and Por�olio Management 12e Frank Reilly, Keith Brown, Sanford Leeds (Solu�ons Manual All Chapters, 100% Original Verified, A+ Grade) 1 / 4

Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12 th

Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting

1 © 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.Solution and Answer Guide FRANK K. REILLY, KEITH, C. BROWN, SANFORD J. LEEDS, INVESTMENT ANALYSIS & PORTFOLIO

MANAGEMENT, 12

TH

EDITION, © 2025, 9780357988176; CHAPTER 1: THE INVESTMENT

SETTING

TABLE OF CONTENTS

Answers to Questions.......................................................................................................... 1 Answers to Problems ......................................................................................................... 5 Appendix 1: Answers to Problems ..................................................................................... 9

ANSWERS TO QUESTIONS

• When an individual’s current money income exceeds his or her current

consumption desires, he or she saves the excess. Rather than keeping these savings in his or her possession, the individual may consider it worthwhile to forego immediate possession of the money for a larger future amount of consumption. This trade-off of present consumption for a higher level of future consumption is the essence of investment.An investment is the current commitment of funds for a period of time in order to derive a future flow of funds that will compensate the investor for the time value of money and the expected rate of inflation over the life of the investment, as well as provide a premium for the uncertainty associated with this future flow of funds.

• Students in general tend to be borrowers because they are typically not employed

and thus have no income (or they are employed with limited income), but they obviously consume and have expenses. The usual intent is to invest the money borrowed in order to increase their future income stream from employment. In other words, students expect to receive a better job and higher income due to their investment in education.

• In the 20–30-year-old segment, an individual would tend to be a net borrower

because s/he is in a relatively low-income bracket and has several expenditures, including automobile(s) and durable goods. In the 30–40-year-old segment, an individual would likely dissave, or borrow, as his or her expenditures would increase with the advent of family life, and conceivably, the purchase of a house.In the 40–50-year-old segment, the individual would probably be a saver because income would increase substantially with no increase in expenditures. Between the ages of 50 and 60, the individual would typically be a strong saver because income would continue to increase and by now the couple would be “empty - nesters.” After this, depending upon when the individual retires, the individual 2 / 4

Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12 th

Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting

2 © 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.would probably be a dissaver as income decreases (transition from a regular income to income from a pension). Of course, the earlier that this individual can start saving, the better off s/he will be. Your goal should be to start saving once you finish school.

• The saving–borrowing pattern would vary by profession to the extent that

compensation patterns vary by profession and time spent in school also varies.For most white-collar professions (for example, lawyers), income would tend to increase with age. Thus, lawyers would tend to be borrowers in the early segments (when income is low) and savers later in life. Alternatively, for blue- collar professions (for example, plumbers), in which skill is often physical, compensation tends to remain constant or decline with age. Thus, plumbers would tend to be savers in the early segments and dissavers in the later segments (when their income declines).

• The difference is because of the definition and the measurement of return. In the

case of the Wall Street Journal, they only refer to the current dividend yield on common stocks, whereas in the case of the University of Chicago studies, they talk about the total rate of return on common stocks, which is the dividend yield plus the capital gain or loss yield during the period. In the long run, the dividend yield has been 4–5 percent, and the capital gain yield has averaged about the same. In recent years, the dividend yield has been closer to 2 percent (and the amount of share repurchases has increased). Therefore, it is important to compare alternative investments based on total return.

• The variance of expected returns represents a measure of the dispersion of actual

returns around the expected value. Everything else remaining constant, the larger the variance is, the greater the dispersion of expectations and the greater the uncertainty, or risk, of the investment. The purpose of the variance is to help measure and analyze the risk associated with a particular investment. A greater variance implies a greater possibility of returns that are very different from your expected return—and that is risk.

• An investor’s required rate of return is a function of the economy’s risk-free rate

(RFR), an inflation premium that compensates the investor for the loss of purchasing power, and a risk premium that compensates the investor for taking the risk. The RFR is the pure time value of money and is the compensation an individual demands for deferring consumption. More objectively, the RFR can be measured in terms of the long-run real growth rate in the economy because the investment opportunities available in the economy influence the RFR. We think of Treasury yields (i.e., the cost of government borrowing) as the RFR. The inflation premium is the additional protection an individual requires to compensate for the erosion in purchasing power resulting from increasing prices. Because the return on all investments is not certain as it is with T-bills, the investor requires a premium for taking on additional risk. The risk premium can be examined in terms of business risk, financial risk, liquidity risk, exchange rate risk, and country risk. 3 / 4

Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12 th

Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting

3 © 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• The three main factors that influence the nominal RFR are the real growth rate of

the economy, the expected rate of inflation, and liquidity (i.e., supply and demand for capital in the economy). The real growth rate and inflationary expectations have positive relationships with the nominal RFR. In other words, the higher the real growth rate, the higher the nominal RFR, and the higher the expected level of inflation, the higher the nominal RFR. Liquidity has an inverse relationship with the nominal RFR, meaning that lower liquidity results in higher yields.It is unlikely that the economy’s long -run real growth rate will change dramatically during a business cycle. However, liquidity depends upon the government’s monetary policy and would change depending upon what the government considers to be the appropriate stimulus. Besides, the demand for business loans would be greatest during the early and middle parts of the business cycle. Inflation can also change significantly during a business cycle.

• The five factors that influence the risk premium on an investment are business

risk, financial risk, liquidity risk, exchange rate risk, and country risk.Business risk is a function of sales volatility and operating leverage, and the combined effect of the two variables can be quantified in terms of the coefficient of variation of operating earnings. Financial risk is a function of the uncertainty introduced by the financing mix. The inherent risk involved is the inability to meet future contractual payments (interest on bonds, etc.) or the threat of bankruptcy.Financial risk is measured in terms of a debt ratio (for example, debt/equity ratio) and/or the interest coverage ratio. Liquidity risk is the uncertainty an individual faces when he or she decides to buy or sell an investment. The two uncertainties involved are: (1) how long it will take to buy or sell this asset and (2) what price will be received. The liquidity risk on different investments can vary substantially (for example, real estate versus T-bills). Exchange rate risk is the uncertainty of returns on securities acquired in a different currency. The risk applies to the global investor or multinational corporate manager who must anticipate returns on securities in light of uncertain future exchange rates. A good measure of this uncertainty would be the absolute volatility of the exchange rate or its beta with a composite exchange rate. Country risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. The analysis of country risk is much more subjective and must be based on the history and current environment in the country.

• The increased use of debt increases the fixed interest payment. Since this fixed

contractual payment will increase, the residual earnings (net income) will become more variable. The required rate of return on the stock will increase since the financial risk (as measured by the debt/equity ratio) has increased.

• According to the Capital Asset Pricing Model (which will be discussed in later

chapters), all securities are located on the Security Market Line, with securities’ risk on the horizontal axis and securities’ expected return on the vertical axis. As to the locations of the five types of investments on the line, the U.S. government

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