Solutions to Chapter 2

The Financial Environment

1.

Yes. When the corporation retains cash and reinvests in the firms operations, that
cash is saved and invested on behalf of the firms shareholders. The reinvested cash
could have been paid out to the shareholders. By not taking the cash, these investors
have reinvested their savings in the corporation. Individuals can also save and invest
in a corporation by lending to, or buying shares in, a financial intermediary such as a
bank or mutual fund that subsequently invests in the corporation.

2.

Overthecounterreferstotradingthatdoesnottakeplaceonacentralized
exchangesuchastheNewYorkStockExchange.Tradingofsecuritieson
NASDAQisoverthecounter,becauseNASDAQisanetworkofsecuritydealers
linkedbycomputers.AlthoughsomecorporatebondsaretradedontheNewYork
StockExchange,mostcorporatebondsaretradedoverthecounter,asareallU.S.
Treasurysecurities.Foreignexchangetradingisalsooverthecounter.

3.

Moneymarkets,whereshorttermdebtinstrumentsareboughtandsold.
Foreignexchangemarkets.Mosttradingtakesplaceinoverthecounter
transactionsbetweenthemajorinternationalbanks.
Commoditiesmarketsforagriculturalcommodities,fuels(includingcrudeoiland
naturalgas)andmetals(suchasgold,silverandplatinum).
Derivativesmarkets,whereoptionsandotherderivativeinstrumentsaretraded.

4.

Buysharesinamutualfund.Mutualfundspoolsavingsfrommanyindividual
investorsandtheninvestinadiversifiedportfolioofsecurities.Eachindividual
investorthenownsaproportionateshareofthemutualfundsportfolio.

5.

Definedcontributionpensionplansprovidethreekeyadvantagesasvehiclesfor
retirementsavings:

Professionalmanagement.
Diversificationatlowcost.
Pensionplancontributionsaretaxdeductible,andtaxesontheearningsinthe
fundaredeferreduntilthefundsassetsaredistributedtoretiredemployees.

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6.

Yes.Insurancecompaniessellpoliciesandtheninvestpartoftheproceedsin
corporate bonds and stocks and in direct loans to corporations. The returns from
these investments help pay for losses incurred by policyholders.

7.

The largest institutional investors in bonds are insurance companies. Other major
institutional investors in bonds are pension funds, mutual funds, and banks and other
savings institutions. The largest institutional investors in shares are pension funds,
mutual funds, and insurance companies.

8.

Themarketpriceofgoldcanbeobservedfromtransactionsincommoditymarkets.
Forexample,goldistradedontheComexdivisionoftheNewYorkMercantile
Exchange.Lookupthepriceofgoldandcompareitto$1500/6=$250perounce.

9.

Financialmarketsprovideextensivedatathatcanbeusefultofinancialmanagers.
Examplesinclude:

10.

Pricesforagriculturalcommodities,metalsandfuels.
Interestratesforawidearrayofloansandsecurities,includingmoneymarket
instruments,corporateandU.S.governmentbonds,andinterestratesforloans
andinvestmentsinforeigncountries.
Foreignexchangerates.
Stockpricesandoverallmarketvaluesforpubliclylistedcorporationsare
determinedbytradingontheNewYorkStockExchange,NASDAQorstock
marketsinLondon,Frankfurt,Tokyo,etc.

Theopportunitycostofcapitalistheexpectedrateofreturnofferedbythebest
alternativeinvestmentopportunity.Whenthefirmmakescapitalinvestmentson
behalfoftheownersofthefirm(i.e.,theshareholders),itmustconsiderthe
shareholdersotherinvestmentopportunities.Thefirmshouldnotinvestunlessthe
expectedreturnoninvestmentatleastequalstheexpectedreturntheshareholders
couldobtainontheirownbyinvestinginthefinancialmarkets.
Theopportunitycostofcapitalforasafeinvestmentistherateofreturnthat
shareholderscouldearniftheyinvestedinriskfreesecurities,forexampleinU.S.
Treasuries.

11.

a.

False. Financing could flow through an intermediary, for example.

b.

False.Investorscanbuysharesinaprivatecorporation,forexample.

c.

True.Saleofinsurancepoliciesarethelargestsourceoffinancingfor
insurancecompanies,whichtheninvestasignificantportionoftheproceeds
incorporatedebtandequities.

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d.

False.ThereisnocentralizedFOREXexchange.Foreignexchangeistraded
overthecounter.

e.

False.Theopportunitycostofcapitalistheexpectedrateofreturnthat
shareholderscanobtaininthefinancialmarketsoninvestmentswiththesame
riskasthefirmscapitalinvestments.

f.

False.Thecostofcapitalisanopportunitycostdeterminedbyexpectedrates
ofreturninfinancialmarkets.Theopportunitycostofcapitalforrisky
investmentsisnormallyhigherthanthefirmsborrowingrate.12.
Liquidityisimportantbecauseinvestorswanttobeabletoconverttheir
investmentsintocashquicklyandeasilywhenitbecomesnecessaryor
desirabletodoso.Shouldpersonalcircumstancesorinvestment
considerationsleadaninvestortoconcludethatitisdesirabletosella
particularinvestment,theinvestorpreferstobeabletoselltheinvestment
quicklyandatapricethatdoesnotrequireasignificantdiscountfrommarket
value.

12. Liquidityisalsoimportanttomutualfunds.Whenthemutualfundsshareholders
wanttoredeemtheirshares,themutualfundisoftenforcedtosellitssecurities.In
ordertomaintainliquidityforitsshareholders,themutualfundrequiresliquid
securities.
13.

Thekeytothebanksabilitytoprovideliquiditytodepositorsisthebanksability
topoolrelativelysmalldepositsfrommanyinvestorsintolarge,illiquidloansto
corporateborrowers.Awithdrawalbyanyonedepositorcanbesatisfiedfromany
ofanumberofsources,includingnewdeposits,repaymentsofotherloansmadeby
thebank,bankreservesandthebanksdebtandequityfinancing.

14.

a.

Investor A buys shares in a mutual fund, which buys part of a new stock issue
by a rapidly growing software company.

b.

Investor B buys shares issued by the Bank of New York, which lends money to
a regional department store chain.

c.

Investor C buys part of a new stock issue by the Regional Life Insurance
Company, which invests in corporate bonds issued by Neighborhood
Refineries, Inc.

15.

Mutualfundscollectmoneyfromsmallinvestorsandinvestthemoneyincorporate
stocksorbonds,thuschannelingsavingsfrominvestorstocorporations.The
advantagesofmutualfundsforindividualsarediversification,professionalinvestment
managementandrecordkeeping

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16.

Theopportunitycostofcapitalforthisinvestmentistherateofreturnthatinvestors
canearninthefinancialmarketsfromsafeinvestments,suchasU.S.Treasury
securitiesandtopquality(AAA)corporatedebtissues.Thehighestquality
investmentsinTable21paid6.25%peryear.Theinvestmentunderconsideration
isguaranteed,sotheopportunitycostofcapitalshouldbeapproximately6.5%.(A
betterestimateoftheopportunitycostofcapitalwouldrelyoninterestratesonU.S.
Treasurieswiththesamematurityastheproposedinvestment.)

17.

a.

Since the government guarantees the payoff for the investment, the opportunity
cost of capital is the rate of return on U.S. Treasuries with one year to maturity
(i.e., one-year Treasury bills).

b.

Sincetheaveragerateofreturnfromaninvestmentincarbonisexpectedtobe
about20percent,thisistheopportunitycostofcapitalfortheinvestment
underconsiderationbyPollutionBusters,Inc.Purchaseoftheadditional
sequestersisnotaworthwhilecapitalinvestmentbecausetheexpectedrateof
returnis15percent(i.e.,a$15,000gainona$100,000investment),lessthan
theopportunitycostofcapital.

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