CHAPTER 1 THE INVESTMENT ENVIRONMENT PROBLEM SETS. iz Ultimratdy, itis tuethat red assas detervinethe retail wel being of an economy ‘Nevertheless individuals can bent when financal engineering creates new product that allow themto maragetheir portfolios of financid assds more dfidenly. Because bundling and unbundling crestesfancial products with new properties and senstivties to various sources of sk italows investors to hedge particular sources of sk more efficiently. Secuttization requires access toa largenurtber of potertial investors. To atract these investors, the cagtal raket needs (1) safe sem of buses aus ard lou probabity of censor taxation/regulation; (2) awaldeveoped investment banking nds; (3) awidl-developed stam of brokerage and finandalanssctions and (4) weldeveloped media, particularly nancial reporting. “These charactaistics are found in (indeed meke for) a well-developed financial market. ‘Secuttization leads to disintarmecition; thats, securtizaton provides a means for rrarketpaticparts to bypassinterredaries For earrple, motgage backed securities channel funds to the housing market vthout requiring that banks orth insttutons rrekeloans fromthe ov patfolios. As securitization progresses, nancial intermediaries must increase ather actives such as providing shar-erm quilt to consures and sill business aru financial savices. Financial assats mekeit easy for lagefins to raise the capital next finencether investments in ea assas. If General Motos, for erarple, could rot issuestocks or bonds to the general publi, it would have afar more dificut time raising capital. Contraction ofthe sunplyof financial assets would make financing more dificult, thereby increasing thecost of capita. A higher cost of capita reaults in less invest ‘and lower real growth. li(Chapter 01 -Thel rvesment Environment be Evenif the firm does not nead to issue stock in any particular year, the stock market is still impotart to the financial menage. The stock price provi des important information about how the market values thefirn's investrrant projects. For example, if thestock pricerises considerably, managers right conclude that the market bdieves the firm's future prospects arebright. This might bea useful signd to thefinn to proceed with an investment suchas an expansion of the fim's business. In addition, the fact that shares can betraded in the secondary maket makes the shares more attractive to investors since investors know that, when they wish to, they will be able to sdi ther shares. This in tum makes investors more willing to buy shares in aprimary offering, and thus improves the tams on which firms can raise money in the ecuity market. a. Cashisafinancial asset becauseit is the liability of thefederal goverment. b. No. Thecash does not directly add to the productive capacity of theeconony. a Ye. d. Sodety asawholeis worse off, since taxpayers, as a group will make up for the liability. a Thebank loan isa finandal liability for Lanni. (Lanri's OU is the bank'sfinandal asset) Thecach Lami receivesis financial asset. Thenaw finandal asst crester is Lannis promissory nete (that is, Lanri’s |OU to the bank). b, Lami transfers financial assets (cash) to the softwaredevelopas. In retum, Lami ds a real assd. the conpletad software. No financial assets are created or destroyed; cash is sirrply transferred from oneparty to nother. © Lami givesthered asset (the software to Microsoft in exchange for financial asset, L500shares of Microsoft stock. If Microsoft issues new shares in order to pay Lami, then this would represent the creation of new financial assets. Lami exchanges one financial asset (1,500 shares of stock) for another ($120,000). Lamni gives afinancial asset ($50,000 cash) to the bank and gets back another financial asset (Its OU). Theloan is "destroyed" in the transection, since it is retired when paid off and no longer exists 12(Chapter 01 - Thelnvestrert Environment a 10. a. Liabilities & pam Shareholders’ equi Cah SoM Bakes Sonor Computes 30000 Sharcholdas’ equity” 50,000 Total $1000 Total 100000 Ratio of ree asses to total assets =$30,000%100,000 =0.30 Liabilities & feel Shareholders’ equit Software produc? 5 70,000 Bar iosn $50,000 Computers 30,000 Sharcholdars' equity "50,000 Total 5100000 Total 100.000 *Vdued at cost Ratio of real assets to total assets =$100,000/$100,000 =1.0 Liabilities & poe Shareholders’ equity Micresoftshaes $120,000 Bark loan Computers 30,000 Shareholders’ equity Total 3150000 Total Ratio of red asset to total assets = $30,000'$150000 =0.20 Conclusion: when the fim starts up and raises working capital, itis characterized by alow rio of red assds to told asses. When itis in full production, ithas ahigh ratio of rea assas to totd asses. When theproject "shuts down" andthefirmsdlls it Off for cash, financial assets once again replace real assets. For commercial banks, theratio is: $107.5/$10410.9 =0.010 For non-financial firms, the ratio is: $13,295/$25,164 The difference should be expected prirrer’ly because the bu k of the business of financial institutions is to make loans; which are financial assets for financial institutions. 528 Primmery-rmerket transaction Daiivative asses. Investors who wish to hold gold without the complication and cost of physical storage. 13(Chepter 01 - Thelnvestrert Enviroment iL a. A fixed salary means that compensation is (atleast in the short run) independent of thefimssuccess. This seary structure doesnot tie the rranaga’’simmredate compensation to thesuccess of thefirm. However, the manager might view this as thesafest compensation structure and therfore valueit more hichly. b, A-salayy thatis paidin the form of stock in thefimmmeans that thermanagr cers the rmost when thesherehoiders’ wealth is maxinized. This structures therefore most likely to align theinterests of menagass and shareholdas. If stock corrpensation is ‘overdone, however, the rranauer might view it as overly risky since the menaga’ s career is already linked to the fim, and this undiversfied exposure would be ‘@aacerbeted with a large stock position in the firm, © Cal optionson shares of the firm creete grest incentives for rraragass to contsibuteto thefirm’s success. In sorre cases, however, stock options can lead to other agency problerrs. For exanple, armanager with numerous call options might be terrpted to take on avay risky investrrert project, reasoning that if theproj ect succes the payoff wil be huge, while fit fails, the losses are imited to the fost value of the options. Sharcholders, in contrast, beer thelosses as wel as thegains on the project, ‘and might be less wiling to assume that risk. 12, Evenif anindividual shareholder could rronitor and improve menages’ paformance, and 13, 14. thereby increase the value of the firm, thepayoft would be sal, sincethe onmasship share in alargecorporation would bevery srral. For exarrple if you own S1Q.000 of GM stock ard can ncrease the vaueof thefiim by 5%, a very arrbitious goa, you benefit by only: 005 « $10,000 =$500 In contrast a bark thathas a multimillicn-dollar loan outstanding to the fim has abig stake in rreking sure thet thefirm can repay theloan. Itis clearly worthwtile for the benk to spend considerable resources to monitor the firm Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and intemational securities markets. Pension funds accept funds and then invest, on beh of curert and future ratiress, thereby channding funds from one sector of the econonry to another. Venture capital firs pool thefunds of private investors and invest in start-up fins. Banks accept deposits from custorrers and loan thosefunds to businesses, or use the Funds to buy securities of large corporations. ‘Treasury bills serve a purposefor investors who prefer a low-risk investment. The lower average rate of retum compared to stocks is the price investors pay for predictabilty of investment performance and portfoio valu. 14Chapter 01-Thelnvesimert Environment 15. With a “top-down” investing style you focus on acset all cation or the broad composition of the entire portfolio, which is therrajor detervi nent of overall performance. Moreover, top-down managementis the natural way to estabish a portfolio with a level of risk consistent with your tisk tolerance. The disadvantage of an exc/usiveerrphesis on top- down issues is that you may forfet the potential high retums that could result from 16 identifying end concentrating in unciervaluied securities or sectors of the market: With a “bottom-up” investing style, you try to benefit from identifying undervalued securities. The disadvantages that you tend to overlook the overall corrposition 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 menggerrent, thus generating more transaction costs. Finally, your analysis ray be incorrect, in which case you will have fruitlcssly expended effort and rroney attarpting to best a simple buy-and hold strategy. You should be skeptical, If the author actudly knows how to achieve such retums, one must question why theauthor would then beso reatly to sell thesecret to othas. Financial makes ate very competitive; one of the implications of this facts that riches do not come easily. High expected retums require bearing sorre risk, andl obvious bergains ere few and far between, Odds arethat the only one getting rich from the bok is its author. V7, 18 a TheSEC website defines thedifference betwee saving ard investing in tems of theinvestrent altemetives or the financial azsas the indivicual chooses to accuire. According to theSEC webste, saving s the process of acquiring a“safe" Finencial asset and investing s the process of acquiring “risky” financial assots b.Theeconorrist’s dafnition of savings isthe difference beween income and consumption. Investing isthe process of allocating on¢ s savings arrong avalable assds, both real assds and finercial ass. The SEC definitions actually represent (@ccording the econorris’s defrition| two kinds of investment atematives. Asis thecasefor the SEC definitions (see Problem 17), theSIA dines savingand investing as acquisition of altemaive kinds of financial assets. According o treSiA, saving isthe process of acquiring safe assets, generally from a bank, while investing is theacanisition of othar financial asses, such as stocks and bonds. Onthe other hard, theddinitions in the chapter indicate that saving rreans spending ess than one's income, Investingis the process of allocating one’ ssevings arnong financial asses, including sings account deposits and money market accourts ("saving” according tothe SIA), other financial aasits such as Stocks and bonds “investing” according to theSIA, as well as real asses, 15