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CHAPTER 1 THE INVESTMENT ENVIRONMENT

By Glenn Hayes,2014-07-11 18:12
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CHAPTER 1 THE INVESTMENT ENVIRONMENT

    CHAPTER 1: INVESTMENTS: BACKGROUND AND ISSUES

1. a. Cash is a financial asset because it is the liability of the federal government.

     b. No. The cash does not directly add to the productive capacity of the economy.

     c. Yes.

     d. Society as a whole is worse off, since taxpayers, as a group will make up for

    the liability.

2. 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 stock in Microsoft. 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 "destroyed" in the transaction, since it is

    retired when paid off and no longer exists.

3. 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 to total assets = $30,000/$100,000 = 0.30

     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

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Ratio of real to total assets = $100,000/$100,000 = 1.0

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     c.

    Assets Liabilities &

    Shareholders’ equity

    Microsoft shares $120,000 Bank loan $ 50,000

    Computers 30,000 Shareholders’ equity 100,000

     Total $150,000 Total $150,000

     Ratio of real to total assets = $30,000/$150,000 = 0.20

     Conclusion: when the firm starts up and raises working capital, it will be

    characterized by a low ratio of real to total assets. When it is in full production, it

    will have a high ratio of real assets. When the project "shuts down" and the firm

    sells it off for cash, financial assets once again replace real assets.

4. Ultimately, it is true that real assets do 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.

5. The ratio is ($628/$17,252) = 0.036 for the financial sector. The ratio is

    ($9,568/$17,661) = 0.542 for non-financial firms. The difference should be expected

    mainly because the bulk of the business of financial institutions is to make loans that are

    financial assets.

6. a. Primary-market transaction

     b. Derivative assets.

     c. Investors who wish to hold gold without the complication and cost of physical

    storage.

7. 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. 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.

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     c. Call options on shares of the firm create great incentives for managers to

    contribute to the firm’s success. In some cases, however, stock options can lead

    to other agency problems. For example, a manager with numerous call options

    might be tempted to take on a very risky investment project, reasoning that if the

    project succeeds the payoff will be huge, while if it fails, the losses are limited to

    the lost value of the options. Shareholders, in contrast, bear the losses as well as

    the gains on the project, and might be less willing to assume that risk.

8. 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 GM 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.

9. 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.

10. 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.

11. Financial assets make it easy for large firms to raise the capital needed to finance

    their investments in real assets. If General Motors, 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 means less

    investment and lower real growth.

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    12. 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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13. 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, the fact that shares can be traded in the secondary market makes the shares

    more attractive to investors since investors know that, when they wish to, 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.

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” investment strategy, 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” investment strategy, you try to benefit from identifying

    undervalued securities. The disadvantage is that you 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 your level of risk tolerance. In addition, this

    technique tends to require more active management, thus generating more transaction

    costs. Finally, your analysis may be incorrect, in which case you will have 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, the only one getting rich from the book is

    its author.

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