CHAPTER 1: THE INVESTMENT ENVIRONMENT

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. 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 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. If Ford, 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 results in less investment and lower
real growth.
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CHAPTER 1: THE INVESTMENT ENVIRONMENT

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 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, 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 did not add to the productive capacity of the
economy.

b. Yes, the value of the equity held in these assets has increased.

c. 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.

b. 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.

c. 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.

d. 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.

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CHAPTER 1: THE INVESTMENT ENVIRONMENT

8. a.
Liabilities &
Assets
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.
Liabilities &
Assets
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.
Liabilities &
Assets
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, 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.

9. a. For commercial banks, the ratio is: $134.3/$17,532.8 = 0.0077

b. For nonfinancial firms, the ratio is: $23,678/$45,464 = 0.5208
c. 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 non-financial corporations is to invest in equipment,
manufacturing plants, and property. The loans are financial assets for
financial institutions, but the investments of non-financial corporations are
real assets.

10. 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.

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CHAPTER 1: THE INVESTMENT ENVIRONMENT

b. 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.

11. 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.

b. 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.

c. 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.

12. 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 Ford stock and 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.

13. 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.
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CHAPTER 1: THE INVESTMENT ENVIRONMENT

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.

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.

15. 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.

16. 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.

17. Financial assets provide for a means to acquire real assets as well as an expansion
of these real assets. Financial assets provide a measure of liquidity to real assets
and allow for investors to more effectively reduce risk through diversification.

18. Allowing traders to share in the profits increases the traders’ willingness to
assume risk. Traders will share in the upside potential directly in the form of
higher compensation but only in the downside indirectly in the form of potential
job loss if performance is bad enough. This scenario creates a form of agency
conflict known as moral hazard, in which the owners of the financial institution
share in both the total profits and losses, while the traders will tend to share more
of the gains than the losses.
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CHAPTER 1: THE INVESTMENT ENVIRONMENT

19. Answers may vary, however, students should touch on the following: increased
transparency, regulations to promote capital adequacy by increasing the frequency
of gain or loss settlement, incentives to discourage excessive risk taking, and the
promotion of more accurate and unbiased risk assessment.

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