THE INVESTMENT ENVIRONMENT

Bodie et al. Investments 10 th Canadian Edition Solutions Manual © 2022 McGraw-Hill Education Ltd.1-1

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.A 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 well-developed 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 Suncor Energy, 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 makes investments in real assets less profitable/viable leading to lower real growth.

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 Investments 10th Canadian Edition By Zvi Bodie, Alex Kane, Alan Marcus, Lorne Switzer, Maureen Stapleton, Dana Boyko, Christine Panasian (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) All Chapters Solutions Manual Supplement files download link at the end of this file. 1 / 4

Bodie et al. Investments 10 th Canadian Edition Solutions Manual © 2022 McGraw-Hill Education Ltd.1-2 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, Toronto, and London 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 does not add to the productive capacity of the economy.b.Yes, the value of the equity held in these assets has increased.

• 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.

• 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 in order to pay Lanni, then this would represent 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 loan and retire its promissory note. The bank must return the promissory note (financial asset) to Lanni. The loan is now "destroyed" in the transaction, since it is retired when paid off and no longer exists.

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 2 / 4

Bodie et al. Investments 10 th Canadian Edition Solutions Manual © 2022 McGraw-Hill Education Ltd.1-3

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 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/operation, 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.

• This is a 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 they represent an investment in physical

gold, but each investor receives a certificate and no gold. Note that investors can convert the certificate into gold during the four-year period.

• a. 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 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 it as overly risky since the manager’s career is already linked to the firm, and this undiversified exposure would be exacerbated with a large stock position in the firm. 3 / 4

Bodie et al. Investments 10 th Canadian Edition Solutions Manual © 2022 McGraw-Hill Education Ltd.1-4

• A profit-linked salary creates great incentives for managers to contribute to the firm’s

success. However, a manager whose salary is tied to short-term profits will be risk seeking, especially if these short-term profits determine salary or if the compensation structure does not bear the full cost of the project’s risks. Shareholders, in contrast, bear the losses as well as the gains on the project and might be less willing to assume that risk.

• 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 Loblaw stock and you can increase the value of the firm by 5%, a very ambitious goal, you benefit by only: 0.05  $10,000 = $500. The cost, both personal and financial to an individual investor, is likely to be prohibitive and would typically easily exceed any accrued benefits, in this case $500.In contrast, a creditor, such as 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.

• Mutual funds accept funds from small investors and invest, on behalf of these investors,

in the domestic and international securities markets.Pension funds accept funds and then invest in a wide range of financial securities, 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.

• 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 higher liquidity and the predictability of investment performance and portfolio value.

• With a top-down investing style, 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 investing style, you try to benefit from identifying undervalued securities.The disadvantage is that investors might 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 the appropriate level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, the bottom- up analysis may be incorrect, in which case there will be a fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy.

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