THE INVESTMENT SETTING

Investment Analysis and Portfolio Management, 11e Frank Reilly, Keith Brown (Solutions Manual All Chapters)

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© 2019 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CHAPTER 1

THE INVESTMENT SETTING

Answers to Questions

• When an individual’s current money income exceeds his current consumption desires, he

saves the excess. Rather than keep these savings in his 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, but 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 he

is in a relatively low-income bracket and has several expenditures, including automobile(s), durable goods, etc. In the 30–40-year-old segment, the individual would likely dissave, or borrow, as his 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 would probably be a dissaver as income decreases (transition from regular income to income from a pension).

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

patterns vary by profession. 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 measurement of return. In the case of the 2 / 3

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© 2019 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.WSJ, they are only referring to the current dividend yield on common stocks versus the promised yield on bonds. In the University of Chicago studies, they are talking 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. Therefore, it is important to compare alternative investments based upon total return.

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

around the expected value. The larger the variance is, everything else remaining constant, 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.

• 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 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. The inflation premium, which can be conveniently measured in terms of the Consumer Price Index, 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.

• Three factors that influence the nominal RFR are the real growth rate of the economy,

liquidity (i.e., supply and demand for capital in the economy), and the expected rate of inflation. Obviously, the influence of liquidity on the RFR is an inverse relationship, while 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.

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 part of the 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

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