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CHAPTER 1: THE INVESTMENT ENVIRONMENT
PROBLEM SETS
1.
Ultimately, it is true that real assets determine the material well being of an
economy. Nevertheless, individuals can benefit when financial engineering creates
new products that allow them to manage their portfolios of financial assets more
efficiently. Because bundling and unbundling creates financial products with new
properties and sensitivities to various sources of risk, it allows investors to hedge
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. As securitization progresses,
financial intermediaries must increase other activities such as providing short-term
liquidity to consumers and small business, and financial services.
4.
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.
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.
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 endure the damage.
7.
a. The bank loan is a financial liability for Lanni. (Lanni's IOU is the bank's
financial asset.) The cash Lanni receives is a financial asset. The new financial
asset created is Lanni's promissory note (that is, Lanni’s IOU to the bank).
b.
Lanni transfers financial assets (cash) to the software developers. In return,
Lanni gets a real asset, the completed software. No financial assets are created or
destroyed; cash is simply transferred from one party to another.
c.
Lanni gives the real asset (the software) to Microsoft in exchange for a financial
asset, 1,500 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.
Lanni exchanges one financial asset (1,500 shares of stock) for another
($$120,000). Lanni gives a financial asset ($$50,000 cash) to the bank and gets
back another financial asset (its IOU). The loan is
since it is retired when paid off and no longer exists.
8.
a.
Assets
Shareholders’ equityLiabilities &
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
Shareholders’ equity Liabilities &
Software
product*
$$ 70,000 Bank loan
$$ 50,000 Computers
30,000
Shareholders’ equity
50,000
Total
*Valued at cost
$$100,000
Total
$$100,000
Ratio of real assets to total assets = $$100,000/$$100,000 = 1.0
c.
Assets
Shareholders’ equity Liabilities &
Microsoft shares $$120,000 Bank loan $$ 50,000 Computers 30,000
Shareholders’ equity 100,000
Total
$$150,000
Total
$$150,000
Ratio of real assets to total assets = $$30,000/$$150,000 = 0.20
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
off for cash, financial assets once again replace real assets.
9.
For commercial banks, the ratio is: $$140.1/$$11,895.1 = 0.0118 For non-financial
firms, the ratio is: $$12,538/$$26,572 = 0.4719 The difference should be expected
primarily because the bulk of the business of financial institutions is to make loans;
which are financial assets for financial institutions.
10.
a. Primary-market transaction
b.
Derivative assets
c.
Investors who wish to hold gold without the complication and cost of physical
storage.
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. 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
In contrast, 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 national and international securities markets.
Pension funds accept funds and then invest, 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.
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